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. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .241
INTRODUCTION
DEFINITIONS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .242
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .242
THE EARNINGS PROCESS
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .244
FINANCIAL REPORTING OBJECTIVES
REVENUE RECOGNITION CRITERIA . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .245
REVENUE MEASUREMENT . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .246
Concept Review . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .247
APPROACHES TO REVENUE RECOGNITION . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .247
. . . . . . . . . . . . . . . . . . . . . . . . .247
REVENUE RECOGNITION ON A CRITICAL EVENT
REVENUE RECOGNIZED AT DELIVERY . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .248
REVENUE RECOGNITION BEFORE DELIVERY . . . . . . . . . . . . . . . . . . . . . . . . . . . . .251
Completion of Production . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .251
Initiation of Contract . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .252
REVENUE RECOGNITION AFTER DELIVERY
Cash Collection . . . . . . . . . . . . . . . . . . . . . . .
Instalment Sales Method . . . . . . . . . . . . . . . .
The Cost Recovery Method . . . . . . . . . . . . . .
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . .253
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .254
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .254
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .255
Concept Review . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .256
REVENUE RECOGNITION BY EFFORT EXPENDED . . . . . . . . . . . . . . . . . . . . . . . . .256
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .257
LONG-TERM CONTRACTS
Measuring Progress toward Completion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .258
Example . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .259
Completed-Contract Method . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .259
Percentage-of-Completion Method . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .261
Comparison of Results . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .262
Accounting for Losses on Long-Term Contracts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .262
Estimating Costs and Revenues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .264
. . . . . .265
PROPORTIONAL PERFORMANCE METHOD FOR SERVICE COMPANIES
CHOOSING A REVENUE RECOGNITION POLICY . . . . . . . . . . . . . . . . . . . . . . . . . . .265
Concept Review . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .266
RECOGNITION OF GAINS AND LOSSES . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .266
. . . . . . . . . . . . . . . . . . . . . . . . . . . . .267
REVENUE ON THE CASH FLOW STATEMENT
DISCLOSURE . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .268
Concept Review . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .268
SUMMARY OF KEY POINTS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .269
REVIEW PROBLEM . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .270
QUESTIONS
CASES . . . . .
EXERCISES
PROBLEMS
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CHAPTER
6
Revenue Recognition
INTRODUCTION
Revenue recognition is probably the single most difficult issue in accounting. A company’s reported results will vary considerably depending on when it
chooses to recognize revenue. Policies for recognizing revenue are critical, and
contentious. The timing of revenue recognition is especially complex because
the business activities that generate revenue are also complex. Some examples
demonstrate the issues.
In a recent year, a mining company produced 12,000 ounces of gold at a
production cost of $1.2 million. Administrative costs for the year were $0.5 million. Even though the gold could have been sold immediately at a market price
of $400 per ounce, management elected not to sell, expecting the price of gold
to increase in the future. What will the company show as revenue for the period? What will it report as net income? Is the company better or worse off at the
end of the year, compared with the beginning of the year?1
University textbooks are typically ordered and shipped 8 to 12 weeks before
the beginning of a new term, with orders based on anticipated enrolment. Upon
receipt of an order, the publisher ships books in time for stocking before the
term begins. The accompanying invoice calls for payment in 30 or 60 days, and
the bookstore pays the invoice amount in full. Several weeks into the term, a
number of copies of the text remain unsold. Most publishers provide retailers
with the right to return unsold, damage-free books for about six months after
the original shipping date. At what point during this sequence of events should
the publisher record revenue and related expenses on its sales?
Corel Corp., a major developer of computer software (e.g., Corel Draw™
and WordPerfect™) recognized revenue when the company shipped the software to dealers, also recognizing that the company accepted unsold software
back from dealers — ordinarily a perfectly acceptable way to recognize revenue.
But when the company’s fortunes turned down and returns escalated, the company was forced to delay revenue recognition until the inventory was sold by
the retailers, even though the retailers are at arm’s length from Corel.2
Thousand Trails, Inc., develops campgrounds and sells usage rights to
campers for a total membership fee of several thousand dollars. Members are
allowed to use existing campgrounds and campgrounds planned for future
development. One of the attractions of membership is the promise of the inter
1 This example is, in fact, a simplification of the situation faced by the Alaska Gold Company, a
placer gold-dredging company. Alaska Gold mined gold for three straight years without selling
any of its production. In its annual report to shareholders, Alaska Gold reported zero revenues
from gold operations for these periods and thus reported sizeable losses each year because of
period expenses. This is one of many interesting cases in G. Pfeiffer and R. Bowen, Financial
Accounting: A Casebook (Englewood Cliffs, N.J.: Prentice-Hall, 1985), pp. 24–29.
2 John Greenwood, “Gaps in GAAP can lead to different tale on bottom line,” The Financial Post,
February 26, 1998, p. 37.
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CHAPTER 6
Revenue Recognition
esting campgrounds that the company claims will be developed in the future,
although it has limited, if any, legal obligation in this regard. Membership fees can be
paid in full when the contractual arrangement is signed, but the most typical arrangement is for the member to pay a small percentage down and the balance in periodic
instalments over a period of up to seven years. Again the question is when revenue
and related expenses should be recognized.3
These examples demonstrate how even minor departures from ordinary sales
transactions can complicate revenue and expense recognition. A relatively small proportion of Canadian business activity fits into straightforward sales activity. Much
economic activity in Canada involves long-term earnings processes, including the
broad resource and service sectors. The points at which revenue should be recognized
are often not obvious.
This chapter covers the conceptual guidelines for determining when revenue
should be recognized and then covers several specific accounting applications that
have been developed for use in resolving various types of revenue recognition problems. Revenue recognition also affects expense recognition; expense recognition is the
subject of Chapter 7.
DEFINITIONS
What is revenue? It’s not defined on its own as, for example “the value of goods and
services delivered during the period.” Rather, it occurs when the net assets (assets
minus liabilities) of an entity increase because of normal operating activities. The
thought process is sequential, and is balance sheet based. For example, assume that an
entity sells goods on credit. An account receivable is created. This increases assets, and
the entity has revenue based on that increase in assets, barring other complications.
The financial statement concepts in Section 1000 of the CICA Handbook formally define revenues as increases in economic resources, either through increases to
assets or reductions to liabilities. These increases in resources must be the result of
delivering or producing goods, rendering services, or performing other activities that
constitute the entity’s normal business. Expenses are decreases in economic resources,
either through outflows or the using-up of assets or incurrence of liabilities from
delivering or producing goods, rendering services, or carrying out other activities that
constitute the entity’s normal business. The definitions are derivative definitions in
that they are based on the terms assets and liabilities. Therefore, clear understanding
of assets and liabilities is needed in order to understand revenues and expenses.
As we pointed out in Chapter 2, assets are economic resources controlled by an
entity as a result of past transactions or events and from which future economic benefits can be obtained. Liabilities are present obligations of an entity arising from past
transactions or events, the settlement of which may result in the transfer or use of
assets, provision of services or other yielding of economic benefits in the future.4
Although our attention in this chapter is focused on recognition and measurement of
revenue, this discussion cannot be separated from the issues of asset and liability
recognition and measurement.
THE EARNINGS PROCESS
At a conceptual level, a firm earns revenue as it engages in activities that increase the
value (or utility, in economic terms) of an item or service. For example, an automobile parts manufacturer increases the value of sheet metal when it undertakes activi3 Thousand Trails, Inc., is another case found in Pfeiffer and Bowen, Financial Accounting: A Casebook.
4 These definitions are from Section 1000 of the CICA Handbook, “Financial Statement Concepts.”
242
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Financial Reporting Objectives
CHAPTER 6
ties to cut, shape, and weld the sheet metal into automobile fenders. Transporting
completed fenders to a regional wholesale warehouse also adds value because it
makes the fenders readily available for purchase and use by automobile repair shops.
The earnings process is fully completed when the fenders are sold and delivered to a
customer in return for cash or a promise to pay cash: finally, assets actually increase.
All of these activities, and many more, are part of the earnings process.
Exhibit 6-1 graphically illustrates the concept of the earnings process in a highly
simplified setting. It focuses on the process of earning revenue; costs are not included. A firm undertakes many different activities, over the five periods shown, for the
purpose of earning a profit. The top graph depicts the cumulative amount of revenue
the firm has earned over time and thus a constant rate of revenue earned as the different activities are performed. The graph also assumes that we know what the total
amount of revenue will be when the earnings process is complete. Usually there is
considerable uncertainty at the earlier stages of the earnings process (for example,
during the design of a new product) as to whether the product will sell, and for what
amount. This uncertainty is only removed when a price is agreed to, and the product
is delivered to a customer.
The bottom graph in Exhibit 6-1 shows the amount of revenue that could conceptually be recognized in each accounting period as activities in the earnings process
are completed. Because we assume that a constant rate of revenue is earned at each
stage in the earnings process, the amount of revenue is the same for each period. The
shaded area in the bottom graph equals the total amount of revenue earned over the
completed earnings process, which is represented in the top graph by the height of the
cumulative revenue earned at the end of the fifth period.
Do not confuse the conceptual notion that economic value is added (i.e., revenue
is created) at each stage along the way in the production and sale process, with the
accounting revenue recognition issue. The issue in accounting is when during that
earnings process should revenue be recognized by recording the increase in value on
the books?
The earnings process for most companies involves incurring costs to increase the
value of an in-process product. Sometimes the process is very long. The design and
development process for a new commercial airplane can take 5 to 10 years from initial design efforts to the delivery of the first airplane to a customer. Economically, revenue is being earned as each of the many activities is completed, assuming that the
activity brings the company closer to having a saleable product. Companies are
required to provide periodic reports on earnings even when the earnings process
extends over several accounting periods. In these situations, the question of how
much revenue (and expense) to recognize and report in each period must be carefully assessed.
FINANCIAL REPORTING OBJECTIVES
Companies do not necessarily pick their accounting policies with “good accounting”
as their first objective. As we saw in Chapters 1 and 2, companies bring a variety of
motives to the decision, and may wish to maximize or minimize reported net income
and net assets, or affect other key financial statement data in support of their specific financial reporting objectives.
Revenue recognition is an area where firms that are anxious to show increasing
sales and profits have followed a number of questionable and sometimes even
improper accounting procedures. A relatively innocent-looking example occurs when
a firm records as a sale goods that have been ordered for a later delivery. Suppose a
firm receives an order in December for goods that the customer desires to receive in
mid-January. Should the sale be recorded in December or January? Even more problematic would be a transaction in which goods are shipped (and recorded as a revenue) to a customer who regularly purchases such goods in approximately the
Copyright © 2000 McGraw-Hill Ryerson Limited
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CHAPTER 6
Revenue Recognition
EXHIBIT 6-1
Conceptual Representation of the Earnings Process
Cumulative
amount of
revenue
earned to
date in
earnings
process
Accounting
period
Total
amount
of revenue
earned
(known)
1
Design
product
2
3
Acquire
materials
for
manufacturing
product
4
Manufacture
product
5
Transport
to regional
warehouse
Sale of product
to customer and
collection of cash
Profit-directed activities being
performed continuously over time
Accounting period
1
2
3
4
5
Theoretical
revenue
to be
recognized
each period
Design
product
Acquire
materials
for
manufacturing
product
Manufacture
product
Profit-directed activities being
performed continuously over time
244
Transport
to regional
warehouse
Sale of product
to customer and
collection of cash
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Revenue Recognition Criteria
CHAPTER 6
amounts shipped, but who has not yet ordered the goods! There have also been cases
where the invoices for goods shipped after the fiscal year-end are back-dated to the
current fiscal year in order to record them as sales in the earlier period. Yes, this really happens, but it’s not acceptable, either ethically or under GAAP. Such actions are
deliberate attempts to mislead users, and are tantamount to fraud.
The choice of method used to record revenues is an area where ethical questions
are sometimes raised. Thousand Trails, the company mentioned in the introduction
to this chapter, used the point-of-sale method to recognize revenue on its membership
rights transactions. Most of these transactions were instalment sales and the default
rate was high. Since the default rate may be very difficult to estimate with reasonable
accuracy, it has been suggested that the instalment sales method would have been a
more appropriate choice for revenue recognition. The company and its auditor maintained, however, that the point-of-sale method was appropriate because they felt they
could estimate the future default amounts on the instalment receivables with reasonable accuracy. By using the point-of-sale method, Thousand Trails reported rapid
growth in sales and profits even though the company had received only a very small
portion of the reported revenue in cash. Again, this is appropriate so long as the
receivables do eventually convert into estimated amounts of cash. The fact that the
company eventually got into severe financial difficulty, in part because of an unexpectedly large number of defaults on the receivables, reinforced concerns about
whether the point-of-sale method was appropriate in the first place.
Choice of method and implementation of accounting procedures for revenue
recognition must be done with a careful consideration of what is ethical and appropriate for the circumstances.
REVENUE RECOGNITION CRITERIA
When an item is recognized in the financial statements, it is assigned a value and
recorded as an element in the appropriate financial statement(s) with an appropriate
offset to another element (e.g., cash or accounts payable). Recognized items must
meet the definition of a financial statement element, and have a measurement basis
and amount. We know that financial statement elements are based on future economic benefits or sacrifices; these must be probable for recognition to be appropriate.
In addition to the general recognition criteria, the revenue principle provides that
revenue should be recognized in the financial statements when it is
1. earned, and
2. realized or realizable.
Revenues are earned when the company has accomplished what it must do to be entitled to receive the associated benefits of the revenue. In a normal sales transaction,
this occurs when the vendor has transferred all the risks and rewards of ownership to
the customer and has no ongoing managerial control over the item. When the earnings process spans more than one accounting period, revenue can sometimes be recognized even though the earnings process is not completed as long as the costs
required to complete the earnings process can be reliably estimated.
Revenue is realized when cash is received. Revenue is realizable when claims to
cash (for example, financial instruments such as accounts or notes receivable) are
received; such financial instruments can be readily converted into cash. This criterion is also met if the product is a commodity, such as gold or wheat, for which there
is a public market in which essentially unlimited amounts of the product can be
bought or sold at a known or ascertainable market price.
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Revenue Recognition
REVENUE MEASUREMENT
The amount of revenue to recognize is usually less of an issue than when to recognize
it, or how to allocate it. This is because the sales price is typically part of the implicit or explicit contract between the buyer and the seller. Measurement is one of the
recognition criteria, though, and is sometimes a substantive issue. For example, when
a sale agreement sets a price, but establishes extended interest-free payment terms, it
is clear that part of the purchase price relates to interest. Discounting techniques can
be used to separate the principal and interest. For practical reasons, firms do not do
this as long as the interest-free period is short, because the amount of interest would
be immaterial. Discounting would more clearly be appropriate if the term was longer
than a year.
Measurement issues also predominate if the sale transaction is a barter transaction; that is, if the exchange involves only non-monetary goods. For example, an
accountant may prepare a tax return for an innkeeper in exchange for a three-day
weekend vacation at the innkeeper’s facility. At what amount should this transaction
be valued? The accountant could keep track of her time, multiply by her charge-out
rate, and determine the amount she would have billed the client. Alternatively, she
could ascertain the value of the weekend vacation to which she is entitled.
The recommendations in the CICA Handbook, found in Section 3830, “Nonmonetary transactions,” indicate that the transaction should be valued at the fair
value of the asset or service given up. However, if the value of the asset or service
received is more reliable, it should be used to value the transaction.
For our accountant, this means that she’ll look at the value of her time, then look
at the value of the weekend trip, and ask which value she’s more confident about.
Likely she’ll use the value of her time, but a comparison of the two values is always
informative. If they’re close, there’s a high degree of comfort with the decision. It’s
not as easy as it seems: she may have been using otherwise-idle time to do this job,
which implies that her time may not have been “worth” the full charge-out rate. She
may be able to use the vacation weekend only in shoulder periods, when the room
would otherwise have been vacant at the inn — implying that it may not be “worth”
the advertised price. Judgement is pivotal to the measurement process.
The non-monetary transaction rules have one more twist. If the barter transaction is not considered to be the culmination (or completion) of the earnings process,
then the barter transaction is valued at book value of the resource given up. For
example, assume a vendor “sells” a product to a customer, and in return takes a second product, which the vendor plans to sell to yet another company for cash. The
first sale is just a step along the “earnings process” path; the vendor has not yet
reached the destination. Therefore, the second product should be recorded at the
book value of the first product. With no change in net asset value, there is no increase
in resources to drive revenue recognition. Only when the second product is sold for
cash is revenue recognition appropriate. It also is not appropriate to record a gain on
sale if two similar capital assets are exchanged. For example, if two real estate development firms swap apartment buildings, the asset acquired is recorded at the book
value of the asset given up.
Measurement of consideration may also be a problem if the consideration is contingent on another transaction. For example, a customer may agree to pay a vendor
on a sliding scale, based on the amount that the customer, in turn, can sell the product to another firm. If the customer does not have to pay the vendor at all unless the
item is resold, the sale is called a consignment sale, and is not recorded by the vendor until re-sale by the customer. However, there are other versions of a sale contract
where a base price is agreed to, with further price adjustments based on the terms of
eventual re-sale. If these arrangements create uncertainty that is material and unquantifiable, revenue recognition must wait until it is possible to establish the appropriate
amount of consideration.
246
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Revenue Recognition on a Critical Event
1. What is the difference between the concepts of revenue creation and revenue
recognition?
2. In general, what two criteria must be satisfied before revenue can be recognized
in the financial statements?
3. How should revenue be measured in a barter transaction?
CHAPTER 6
CONCEPT
REVIEW
APPROACHES TO REVENUE RECOGNITION
Essentially, there are two approaches to revenue recognition. Revenue can be recognized at one critical event in the chain of activities, for example, production, delivery,
or cash collection. Alternatively, revenue can be recognized on a basis consistent with
effort expended, a plan that would result in some revenue being recognized with
every activity in the chain.
REVENUE RECOGNITION ON A CRITICAL EVENT
What happens if a critical event is chosen to trigger revenue recognition? All costs
incurred before the critical event that can be specifically identified as relating to each
individual earnings event are deferred (usually as inventory costs). These expenditures qualify as assets because they will generate resources/sales revenue at the critical event. When revenue is recognized, deferred expenses are expensed, and identifiable costs that have not yet been incurred must be accrued as estimated liabilities.
Revenues and expenses are all recognized at the critical event, regardless of when they
are incurred. This is the magic of an accrual-based accounting system.
What events could be chosen as the critical event? Potentially, any activity in the
earnings process could be so designated, but the key is that, following the critical
event, the remaining aspects of the earnings process should unfold predictably in the
normal course of business with no major uncertainties or immeasurables. Once the
critical event has occurred, it’s all downhill from there! The most commonly-used
critical events can be grouped by reference to completion of the earnings cycle:
1. Completion
2. Prior to completion
3. Subsequent to completion
Exhibit 6-2 illustrates revenue recognition associated with specific critical events in
the context of production and sale of a manufactured product. Although this figure
uses manufactured goods as the reference point, a similar chart could be drawn for
other earnings cycles, such as for resource extraction, life insurance, or auditing. Not
all possible methods are shown in Exhibit 6-2, even for manufacturing.
For most companies and for most goods and services, revenue is recognized at the
time of delivery of the goods or services to the customer. Revenue is considered both
earned and realized or realizable when the product or service is delivered.
An earlier critical event — production — may be appropriate if the selling and
shipping functions are trivial, such as when the product is a commodity for which
there is an organized market (e.g., wheat, copper, gold). A critical event after delivery is appropriate when there are measurement problems surrounding the amount of
revenue actually generated, collection uncertainties, and/or when it is not possible to
accurately estimate all the costs associated with the earnings process, which must be
fully accrued at the critical event. In the face of any of these problems, revenue recognition should wait until major uncertainties are resolved.
Copyright © 2000 McGraw-Hill Ryerson Limited
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CHAPTER 6
Revenue Recognition
EXHIBIT 6-2
Alternative Methods of Revenue Recognition
Revenue Recognized before Delivery
Products being designed
and produced, construction
contracts in process,
minerals being discovered
Percentage-of-completion
method
Revenue
Recognized
at Delivery
Goods completed
and available
for sale.
Contract completed
Production
method
Delivery of
product
or service
to customer
Revenue Recognized after Delivery
Cash is collected
for goods and
services
Instalment
method
Completedcontract
Point-of sale
method
method
Right of
return
expires
Right of
return
expiration
method
Cost recovery
method
Points in the Earnings Process at Which Revenues May Be Recognized
Revenue information generally considered more RELEVANT when reported earlier
Revenue information generally considered more RELIABLE when reported later
REVENUE RECOGNIZED AT DELIVERY
The two conditions for revenue recognition, (1) revenue is realized or realizable and
(2) revenue must be earned, are usually met at the time goods or services are delivered. Thus, revenue from the sale of products is usually recognized at the date of sale,
meaning the date the product is delivered to the customer. Revenue from services rendered is likewise recognized when the services have been performed and accepted by
the client.
Some transactions do not result in a one-time delivery of a product or service, but
rather in continual “delivery” or fulfilment of a contractual arrangement. For example, revenue from contractual arrangements allowing others to use company assets
(such as revenues from rent, interest, lease payments, and royalties) is recognized as
time passes or as the asset is used. Revenue is earned with the passage of time and is
recognized accordingly.5
Separately identifiable costs incurred prior to the critical event are deferred in
inventory or other deferred asset accounts. These costs are recognized as expenses at
delivery, and thus are recognized at the same time as revenue. All other costs associated with the sale must be recognized in the same period as the revenue; this may
include a reasonable estimate of bad debts, and a provision for guarantee or warranty costs. Refer to the sequence of events in Exhibit 6-3, where a company buys inventory, customizes it, and then holds it until sale. It is sold, on account, subject to a fourmonth warranty. Subsequently, the customer pays, some warranty costs are incurred,
5 If, however, the contract is a lease and is essentially a noncancellable transfer of all the risks and rights
of ownership of the asset, the transaction qualifies as a sale. Such transactions, called capital leases,
are considered in Chapter 18.
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EXHIBIT 6-3
Critical Events and Impact on Net Assets
Data:
January 15
January 17
March 6
April 30
June 14
July 6
Date
Jan. 15
Inventory purchased, $14,500
Inventory repackaged and customized, labour and materials cost, $2,250.
Now ready for sale.
Inventory delivered to customer on account. Agreed-upon price, $27,500.
Collection is assured; there is a four-month warranty.
Customer paid.
Warranty work done, at a cost of $3,900.
Warranty expired.
Pre-delivery:
Production
Delivery
Inventory
Cash, A/P, etc.
Effect on
None
net assets
Jan. 17
Inventory
Cash, A/P, etc.
14,500
14,500
Inventory
Cash, A/P, etc.
Effect on
net assets
None
14,500
14,500
None
2,250
2,250
Inventory
Cash, A/P, etc.
Cost of goods sold
Inventory
Revenue
Warranty expense
Estimated warranty
liability
Effect on
None
net assets
March 6
Accounts receivable
Revenue
Cost of goods sold
Inventory
Warranty expense
Estimated warranty
liability
Effect on
Increase
net assets
April 30
Cash
Accounts receivable
Effect on
None
net assets
June 14
Estimated warranty
liability
Cash
Effect on
None
net assets
July 6
No entry
Post-delivery:
Warranty Expiration
Increase
27,500
27,500
Accounts receivable
Inventory
Inventory
Cash, A/P, etc.
14,500
14,500
None
2,250
2,250
Inventory
Cash, A/P, etc.
2,250
2,250
16,750
10,750
27,500
3,900
3,900
$6,850
None
27,500
27,500
16,750
Accounts receivable 27,500
Deferred gross margin
10,750
Inventory
16,750
16,750
3,900
3,900
$6,850
None
27,500
27,500
None
Cash
27,500
Cash
27,500
Accounts receivable
27,500
Accounts receivable
27,500
None
3,900
Estimated warranty
liability
3,900
Cash
None
3,900
None
No entry
3,900
Deferred warranty
costs
Cash
3,900
3,900
None
Cost of goods sold 16,750
Deferred gross margin 10,750
Revenue
27,500
Warranty expense
3,900
Deferred warranty
costs
3,900
None
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Increase $6,850
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and, finally, the warranty expires. The first column of Exhibit 6-3 traces the entries
appropriate if delivery is considered to be the critical event. Product costs are deferred
in the inventory account until delivery. When the item is delivered, the sales price is
accrued, inventory is expensed to cost of goods sold, and warranty costs are estimated — with amazing accuracy! Collection is assumed to be certain, and no bad debt
accrual is appropriate. Subsequent cash transactions — cash collection and payment
of warranty costs — change receivables and payables established at the critical event.
Net assets are increased only at the critical event. Other transactions change the composition but not the total of net assets. The remaining columns of Exhibit 6-3 will be
analyzed in later sections.
For companies that sell services rather than products, revenue recognition policies are analogous to the policies of companies selling tangible goods. Service revenue
is usually recognized when performance is complete. Of course, the revenue is really
earned by performing a series of acts, but recognition may be considered appropriate
only after the final act occurs. This final act is often analogous to delivery of a tangible good, and signifies that the customer accepts the service. For example, a consultant recognizes revenue only when an assignment has been completed. A trucking
firm recognizes service revenue only after delivery of freight, even though packing,
loading, and transporting preceded delivery. A laundry recognizes revenue when
items are picked up by the customer.
Accounting for franchise fee revenue provides an example of the sorts of problems that can be encountered when trying to identify when “delivery” has occurred
in a service transaction. Franchisees usually agree to pay a substantial fee to the franchisor. For revenue recognition purposes, it is often difficult to determine when the
earnings process is complete and the franchisor’s service has been delivered — the
point at which the franchisor has “substantially performed” the service required to
earn the franchise fee revenue.
One common problem with franchise fee revenue recognition is that of evaluating the collectibility of the initial fee. If the franchisee pays the fee up front, this is less
of a concern; if the franchisee plans to pay it over time with profits from the franchise
operation, then collection is contingent on profitable operations, and careful assessment of business risk is necessary. A franchisor with no track history, or with franchisees that are financially unsound, may have to delay revenue recognition due to
collection concerns.
Another problem is that the franchisor may have significant ongoing obligations
to the franchisee. If this is the case, and if the franchisee does not have to pay extra
for these services (that is, they are part of the services encompassed by the initial franchise fee) recognition of all or part of the initial franchise fee might be delayed.
To help franchisors (and their auditors) deal with the problems of franchise fee
revenue recognition, the CICA issued an Accounting Guideline many years ago.6 The
guideline suggests that “substantial performance” has occurred only when:
a. The franchisor has performed substantially all of the initial services required
by the franchise agreement or volunteered by the franchisor as a result of normal business practice.
b. The franchisor has no remaining obligation or intent to refund amounts
received or forgive unpaid amounts owing.
c. There are no other material unfulfilled conditions affecting completion of the
sale.
Thus, “delivery” has occurred only when the franchisor has done what is expected
and gets to keep the money.
6 “Franchise Fee Revenue,” Accounting Guidelines, CICA Handbook, July 1984.
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CHAPTER 6
REVENUE RECOGNITION BEFORE DELIVERY
Completion of Production
In certain situations, revenue can be recognized at the completion of production but
prior to delivery. The key criterion for using this method is that the sale will take
place without any doubt. The normal criteria for recognizing revenue before sale are
•
•
•
•
the sale and collection of proceeds must be assured;
the product must be marketable immediately at quoted prices that cannot be
influenced by the producer;
units of the product must be interchangeable; and
there must be no significant costs involved in product sale or distribution.
Essentially, these criteria define a commodity. Examples include agricultural products, precious metals, and other goods that are traded on commodities markets such
as orange juice concentrate, crude oil, and pork bellies. Commodities can be sold at
any time simply by lifting the telephone and calling a broker; no significant effort is
required. When this approach to revenue recognition is used, the increase in net asset
value is recorded immediately upon the completion of production, and involves valuing inventory at market value.
While commodities that are traded on a public market are the most obvious candidates for pre-delivery revenue recognition, some companies may use this method if
their product is in such strong demand that sale is virtually assured. It is a bit dangerous, however, because if demand suddenly falls off, the company is left with a lot
of inventory carried at market value but no ready buyers. Substantial effort is then
required to sell the product, which means that the earnings process is not complete
and the criteria for revenue recognition have not been met.
Refer to the second column of Exhibit 6-3, which demonstrates the sequence of
entries that would be appropriate for revenue recognition on the completion of production. When inventory is customized and ready for sale, revenue is recognized in
full by increasing the inventory value from its cost of $16,750 (that is, $14,500 plus
$2,250) to market value ($27,500), a difference of $10,750. On the income statement, the gross margin will be disaggregated and will be presented as sales of
$27,500 and cost of sales of $16,750.7
At the same time the inventory is revalued, warranty costs are accrued, to include
all costs of the sale in the same accounting period. Note that the overall change in net
assets is $6,850, the same that was recorded under the “delivery” alternative. All that
has changed is the point at which the increase in net assets is recognized. After the
critical event (i.e., production), all transactions change the allocation of the net asset
balances but do not increase or decrease total net assets.
Completion of production for a service company is the completion of the service,
also called specific performance. Is this any different than “delivery”? For many service activities, services are completed and delivered simultaneously (consider haircuts,
tooth extractions, music lessons, and so on).
But what if the service is performed and only later accepted by the customer? For
example, a consulting report could be written but not presented to the client for a
month. Would it make sense to recognize revenue when the work is completed, prior
to delivery? As in tangible products, this would be aggressive, as the risks and
rewards have not yet passed to the client; there is no assurance that the consultant
has fulfilled her or his mandate.
7 Bear in mind that Canadian GAAP requires the amount of revenue recognized to be disclosed on the
income statement [CICA 1520.03(a)].
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As a result, revenue recognition at production for service sales is not normally
appropriate. In many cases, the lag between production and delivery is likely to be nonexistent or very short, and so this isn’t much of an issue for most short-term service
sales. But long-term service contracts may result in partial recognition of revenue, period by period, as work is performed. This process will be discussed in a later section.
Initiation of Contract
To achieve matching, it is necessary to recognize revenue and the related expenses in
the same period. However, GAAP does not approve of the deferral of many types of
cost that cannot be specifically identified with a unit of product or service.
Promotional expenses, for example, can be deferred to a later period if they relate
specifically to that later period, such as the cost of preparing television advertisements
which will be aired in the next period, or the cost of publishing a printed catalogue
for next year’s product line. General advertising and promotional costs cannot be
deferred, however, because it is impossible to have reasonable assurance that revenues
will arise in the future as the result of this year’s promotion.
On rare occasions, a large part of an enterprise’s cost is in its promotional activities or in other non-deferrable costs. An example is a company that sells selfimprovement home study courses by correspondence. The costs for developing the
courses are incurred early, followed by a major TV and print media blitz to sign up
customers. The course development costs can be deferred, of course, but the cost of
the promotional campaign cannot.
Therefore, such a company may choose to recognize revenue when it signs up the
customer and receives the cash. The costs of actually delivering the course may be relatively trivial (e.g., printing and mailing costs, and perhaps grading costs that are
tightly budgeted and controlled) and are quite predictable; the future costs of delivering the course can be accrued at the time of revenue recognition. Therefore, the critical event is perceived to be the sale.
Recognizing revenue at the inception of a contract is usually regarded as aggressive accounting policy. Companies that use an aggressive policy and later get into
financial difficulty usually find themselves the brunt of aggressive analysts and
lawyers. Loewen Group Inc., a very large funeral services company, used early recognition of revenue on the sale of cemetery plots. The sales contracts were usually
instalment sales, and the customer paid little or nothing at inception. The revenue for
the entire contract was booked in the period that the sale was made, which is industry practice. Getting the sale is the critical event. This practice was used by Loewen
for years without raising the concerns of analysts, but once the company got into difficulty (for largely unrelated reasons), it was accused of aggressive accounting.8
Another example is that of Livent Inc. Livent sold the rights to the name of its
theatres in Vancouver and Toronto to Ford and to AT&T Canada. The sale was for
the right to attach the corporate sponsor’s name to the theatre for a limited period,
usually 10 years. Clearly, the critical event was making the sale. There could be little
doubt that Ford and AT&T would come up with the cash, and Livent didn’t have to
do anything to earn the revenue — just put the name on the theatre and leave it there!
Therefore, Livent recognized the full amount of the sales contract at the time of signing, regardless of whether or not the cash was received. Later, analysts (and lawyers)
attacked this practice, claiming that the revenue should have been deferred and amortized (the Canadian solution to many accounting problems!).9
8 “A Deathwatch for Loewen Group,” The Globe and Mail, 1 August 1998, p. B1.
9 “Fund Companies Write Down Their Investments in Livent,” The Globe and Mail, 14 August 1998, p. B1.
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CHAPTER 6
REVENUE RECOGNITION AFTER DELIVERY
In certain circumstances, revenue recognition must be delayed until after delivery.
Typically, this is appropriate when there are uncertainties over the costs associated
with the remaining activities in the earnings process, collection, or measurement.
Revenue from the sale of goods should only be recognized when the risks and
rewards of ownership pass from the vendor to the customer; substantially all of the
elements of the earnings process must be complete before this condition is considered
to be met. What if there is a major warranty associated with the sale? This may preclude revenue recognition until the task — the risk — is over. Refer to the third column of entries in Exhibit 6-3. This alternative is appropriate if the cost of the warranty is not estimable at the point of sale, or any point up to its expiration, and is
expected to be material.
Notice here that product costs are capitalized in inventory, and even delivery does
not cause a change in net assets. Accounts receivable are recognized, inventory is
reduced, but the gross margin is deferred; the deferred gross margin account is a contra account to accounts receivable on the balance sheet. Warranty costs actually
incurred are deferred. None of the transactions prior to the critical event — the expiration of the warranty period — triggers a change in net asset value.
As previously discussed, if the amount of consideration — the sales amount —
cannot be ascertained, revenue is recognized when those uncertainties are resolved. In
a contract that involves a sliding scale of payment to the vendor based on the price
the customer receives on the resale of the item, the critical event would be the resale
of the goods for an ascertainable price.
In several industries, such as book publishing and equipment manufacturing, the
sales terms allow customers the right to return goods under certain circumstances and
over long periods of time. Thus, on delivery, the amount that will ultimately become
realizable is not known.
The revenue section of the CICA Handbook states the following:
Revenue would not be recognized when an enterprise is subject to significant and unpredictable amounts of goods being returned, for example,
when the market for a returnable good is untested. If an enterprise is
exposed to significant and predictable amounts of goods being returned, it
may be sufficient to provide therefore.
[CICA 3400.18]
This latter point deserves special emphasis; if the risk can be quantified, then the sale
can be recorded on delivery and the contingency accrued.
No revenue should be recognized if the buyer’s obligation to pay the seller is contingent on the resale of the product. If payment is contingent, this is a consignment:
a marketing arrangement in which the owner of the product (the consignor) ships the
product to another party (the consignee) who acts as a sales agent. The consignee
does not purchase the goods, but assumes responsibility only for their care and resale.
Upon sale, the consignee remits the proceeds (less specified expenses and commission)
to the consignor. Goods on consignment are part of the inventory of the consignor
until sold by the consignee. They are not a sale of the consignor when shipped to the
consignee, but only when they are sold by the consignee.
Product-financing arrangements include agreements in which a sponsoring company sells a product to another company and in a related transaction agrees to repurchase the product at some future point in time if the customer has been unable to
resell the product. This is consignment selling in a different legal form, and it is clear
that the risks and rewards of ownership have not passed to the customer.
In these kinds of product-financing agreements, the sponsoring company must
record a liability at the time the proceeds are received. It can neither record a sale nor
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remove the product from its inventory account. Only when the product is sold to an
outside party without a related repurchase agreement can the sponsoring company
record a sale.
Cash Collection
It is not appropriate to recognize revenue if it is not realized or realizable; accounts
receivable must be collectible in order to support an entry that recognizes revenue. If
there is no way to quantify collection risk, the critical event becomes cash collection
and increases in net asset values are deferred until that time.
However, there is usually some degree of collection risk in every credit sale and
delayed revenue recognition is not the norm. Instead, the risk is quantified by estimating an allowance for doubtful accounts, and associated bad debt expense. As long
as there is some objective basis for the allowance, such as past history, credit reports,
etc., revenue recognition prior to cash collection can be justified.
When the eventual collection of cash is uncertain, companies usually delay revenue recognition until the cash is actually collected. This is common in certain types
of retail stores, where credit terms are extended to customers that have very shaky
credit records. The company compensates for its high default rate on bad credit by
charging high interest to those who do pay and by having a well-organized repossession service.
Recognizing revenue on cash collection does not mean that it is appropriate to
recognize revenue prior to delivery, if cash is received prior to delivery and there are
major costs to be incurred to fulfill the contract with the customer. For example,
when a publisher sells a magazine subscription or an airline sells a ticket for future
air travel, cash is received before delivery of the product or service. The realizability
criterion is met, but significant effort and cost must be incurred before the earnings
process is substantially complete; the earnings process is not completed until the
product is delivered.
In this case, cash inflow does not result in revenue but in an obligation to produce and deliver the product: a liability. This liability is called deferred revenue or
unearned revenue. The revenue is not recognized until the product or service is delivered. The topic under consideration in this section is delayed revenue recognition:
when cash is collected after delivery.
If revenue is recognized on cash collection, the sequence of entries would be similar to those in the third column of Exhibit 6-3. Cost would be deferred and delivery
would only result in recognition of a deferred margin. On cash collection, warranty
costs would be accrued, and the cash collection would trigger recognition of the gross
margin. Net assets would increase accordingly.
The example in Exhibit 6-3 is relatively straightforward, since the customer has
paid in one complete lump sum. However, when cash collection is uncertain, the sale
agreement often involves a series of payments for the customer. Then, the company
must determine which of two revenue recognition approaches fits its risk profile: the
instalment sales method or the cost recovery method.
Instalment Sales Method
Many consumer products are sold on an instalment or deferred payment plan, in
which a purchaser makes payments in accordance with a periodic payment plan. If
the company has a reasonable basis for estimating an allowance for uncollectible
accounts, the company can choose to recognize revenue immediately, at the time of
the sale.
However, a company that sells its products on an instalment plan may choose to
use the instalment sales method of accounting. Revenue under the instalment sales
method is recognized when cash is collected rather than at the time of sale. Under this
method, revenue (and the related cost of goods sold) are recognized only when realized. For instance, the instalment method may be used to account for sales of real
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estate when the down payment is relatively small and ultimate collection of the sales
price is not reasonably assured.
For example, assume that Truro Company makes $80,000 of instalment sales in
20X2. The cost of goods sold is $60,000, and thus the gross margin is $20,000, or
25% of sales. The sale is recorded with a deferred gross margin.
Instalment accounts receivable
Inventory
Deferred gross margin
80,000
60,000
20,000
The deferred gross margin will appear as a liability on the balance sheet, as deferred
revenue. Notice that the entry to record the sale does not result in an increase in the
company’s net assets, because the increase of $20,000 in assets (that is, the increase
from $60,000 inventory to $80,000 accounts receivable) is completely offset by the
$20,000 increase in the liability.
If $10,000 is subsequently collected, the entries to record the collection and to
recognize a proportionate part of the deferred revenue are as follows:
Cash
Instalment accounts receivable
10,000
Deferred gross margin ($10,000 25%)
Cost of goods sold
Sales revenue
10,000
2,500
7,500
10,000
It is the last entry that records the increase to net assets that is the sign of revenue
recognition. The increase in net assets is accomplished by reducing the amount of the
liability for deferred gross margin. Note that the revenue recognition is recorded by
disaggregating the realized gross margin of $2,500 into its two components of Sales
and Cost of goods sold. This is in accordance with the CICA Handbook recommendation that the gross amount of revenue be disclosed on the income statement.
The Cost Recovery Method
The cost recovery method is sometimes called the sunk cost method. A company must
recover all the related costs incurred (the sunk costs) before it recognizes any profit.
The cost recovery method is used for highly speculative transactions when the ultimate realization of revenue or profit is unpredictable.
The method makes an even match of revenue and expense until all of the deferred
cost has been recovered. Only then is any profit recognized. It is common only under
extreme uncertainty about collection of the receivables or ultimate recovery of capitalized production start-up costs.
An example is Lockheed Corporation’s use of the cost recovery method in the
early 1970s when it faced great uncertainty regarding the ultimate profitability of its
TriStar Jet Transport program. Lockheed had invested more than $500 million in the
initial planning, tooling, and production start-up costs of its widebody aircraft, the
L-1011 TriStar. These costs were to be amortized over the production and sale of the
first 300 planes, but considerable uncertainty developed concerning how many airplanes might ultimately be sold: the TriStar program might not generate enough sales
to recover the development costs. Note 2 to Lockheed’s 1973 annual report reported the company’s decision to use the cost recovery method for revenue recognition for
its TriStar program (italics added):
All of the development costs and the normal production costs on the
TriStar Jet Transport have been included in the inventory except for
General and Administrative expenses which are charged to income in
the year incurred. G & A expenses amounted to $70 million in 1973 and
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$81 million in 1972. Since the cumulative development costs to date
have been substantial, it is estimated that 300 aircraft will have to be
delivered to make the total program profitable. Since 56 aircraft have
been delivered to date (all during 1972 and 1973), the Company does
not expect a final determination of recoverability of Inventoried Cost can
be made until a later date. Zero gross profit was recorded on the $730
million of sales in 1973 and $302 million in sales in 1972 (for deliveries in
those years) and no gross profit will be recorded on deliveries until
uncertainties are reduced.10
The cost recovery method is also justified when there is significant uncertainty
regarding the ultimate collectibility of a string of customer payments. Cost recovery
accounting is not uncommon in the real estate industry.
For example, assume that the Peninsula Land Sales Company sold undeveloped
land during 20X4, with an original cost of $80,000 and a contract sales price of
$140,000, to be paid, with interest, over the next five years. Collection is deemed to
be highly uncertain. The first $80,000 that is collected is, in essence, credited to the
land account; the last $60,000 collected is all profit. If collections cease after
$60,000, the adjusted cost basis for the land is $20,000, and it is recorded as an asset
at the lower of cost or market.
This revenue recognition method is highly skewed toward later revenue recognition and does a poor job of reflecting performance and cash flows. Its use is justified
only in the face of significant uncertainties.
CONCEPT
REVIEW
1. What is meant by the critical event in revenue recognition?
2. What is the net balance sheet effect of revenue recognition?
3. What criteria must ordinarily be satisfied in order for revenue to be recognized
on production, prior to sale or delivery?
4. When would revenue recognition be delayed to a point later than production,
sale, and delivery?
REVENUE RECOGNITION BY EFFORT EXPENDED
So far, our discussion has examined the critical event approach to revenue recognition: identify one event in the earnings process, and recognize revenue and related
costs at that event (which could involve multiple events for a single revenue-generating transaction, if the critical event is cash receipt).
An alternative to the critical event approach is to recognize revenue as effort is
expended along each step in the earnings process. Think about the increase in value
resulting from natural causes such as the growth of timberland or the aging of wines
and liquors. As the product’s value increases, revenue is being earned in an economic sense, and some accountants believe that it should be recognized. Recognition may
be important when the natural process is very long, and knowing the change in value
is relevant information for decision-making. Could you measure the change in value?
This approach to revenue recognition is not practical in the vast majority of situations: imagine trying to figure out how much a forest grew in a year, or trying to
allocate the gross profit associated with a sale of manufactured goods to each activity in the process. Which of the tasks (getting the order, procuring raw materials, man10 In 1975, Lockheed reclassified TriStar’s initial planning, tooling, and unrecovered production start-up
costs as deferred charges and began amortizing them in the amount of approximately $50 million per
year. This was done because of “increased uncertainties” regarding the number and timing of future
TriStar deliveries. This write-off procedure was a means of spreading the loss over future years. A preferred alternative would have been to write off the entire amount immediately.
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ufacturing, shipping, providing after-sales support, etc.) is the most valuable? The
allocation problem would be a nightmare!
But accountants can and have solved allocation problems before. The more serious problem is that the revenue principle is not satisfied at any time prior to delivery.
Risks and rewards of ownership have not passed to the customer, and the increase in
net asset value is not, therefore, reasonably assured. Remember, revenue recognition
prior to delivery is aggressive, and rare except in special industries. Notwithstanding
this fact, there are a few cases where it is not only acceptable, but even desirable, to
take the required leap of faith and recognize revenue as effort is expended.
LONG-TERM CONTRACTS
In some instances the earnings process extends over several accounting periods.
Delivery of the final product may occur years after the initiation of the project.
Examples are construction of large ships, office buildings, development of spaceexploration equipment, and development of large-scale custom software. Contracts
for these projects often provide for progress billings at various points in the earnings
process.
If the seller waits until the project or contract is completed to recognize revenue,
the information on revenue and expense included in the financial statements will be
reliable, but it may not be relevant for decision-making because the information is not
timely.
For example, the financial reporting objective of performance evaluation is reasonably well served only if the financial statements report on the results of the enterprise’s economic activity during the period. Delaying revenue recognition on longterm projects until the project is complete tells the financial statement reader nothing
about economic activity (i.e., performance) during the period.
The cash flow reporting objective also is not well served by delaying revenue recognition, because the cash is flowing out (and usually in, as well) as the project is performed,
not at the end. Therefore, it often is worthwhile to trade off reliability in order to provide
more timely, relevant earnings information. There are two general methods of accounting
for revenue on long-term contracts:
1. Completed-contract method. Revenues, expenses, and resulting gross profit are
recognized only when the contract is completed. As costs are incurred, they are
accumulated in an inventory account (projects in progress). Progress billings are
not recorded as revenues, but are accumulated in a billings on projects in progress
account that is deducted from the inventory account (i.e., a contra account to
inventory). At the completion of the contract, all the accounts are closed, and the
entire gross profit from the project is recognized.
2. Percentage-of-completion method. The percentage-of-completion method recog-
nizes revenue on a long-term project as work progresses so that timely information is provided. Revenues, expenses, and gross profit are recognized each
accounting period based on an estimate of the percentage of completion of the
project. Project costs and gross profit to date are accumulated in the inventory
account (projects in progress). Progress billings are accumulated in a contra
inventory account (billings on projects in progress).
The CICA Handbook recommends that revenue from long-term contracts should be
recognized by whichever method “relates the revenue to the work accomplished”:
Such performance should be regarded as having been achieved when reasonable assurance exists regarding the measurement of the consideration
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that will be derived from rendering the service or performing the long-term
contract.
[CICA 3400.08]
The percentage-of-completion and completed-contract methods are not intended to
be free choice alternatives for the same circumstances. Is there a contract that establishes the contract price with a high degree of reliability? Is collection reasonably assured?
These conditions would be met by the standard provisions of a long-term contract that
involves a creditworthy customer expected to make regular progress payments.
The critical criteria are whether the seller can estimate with reasonable assurance
(1) the progress toward completion of the contractual obligation and (2) the costs to
complete the project. If these criteria are met, percentage of completion is the method
that very clearly relates the revenue to the work performed. If the criteria are not met,
the completed-contract method should be used. Of course, judgement plays a role in
determining whether the criteria are met, and particular reporting objectives usually
influence the selection of method.
Measuring Progress toward Completion
Measuring progress toward completion of a long-term project can be accomplished
by using either input measures or output measures:
1. Input measures. The effort devoted to a project to date is compared with the total
effort expected to be required in order to complete the project. Examples are (1)
costs incurred to date compared with total estimated costs for the project and (2)
labour hours worked compared with total estimated labour hours required to
complete the project.
2. Output measures. Results to date are compared with total results when the pro-
ject is completed. Examples are the number of kilometres of highway completed
compared with total kilometres to be completed, or progress milestones established in a software development contract.
An expert, such as an engineer or architect, is often hired to assess percentage of completion or achievement of milestones, which is an art, not a science.
The goal is to have a realistic measure of progress made toward completion of
the project. Neither input nor output measures are always ideal. Input measures are
often used when it is difficult to measure progress using output measures. However,
input measures can be misleading when no relatively constant relationship between
the input measure and productivity exists. Cost overruns on projects would cause
erroneous levels of completion to be estimated. Costs incurred also may be misleading as a measure of progress if costs include one-time, up-front expenditures for
quantities of materials and supplies to be used during the construction period.
Despite their shortcomings, input measures are most frequently used because they
are the most readily available. Among input measures, the cost-to-cost method is the
most common. The cost-to-cost method measures the percentage completed by the
ratio of costs incurred to date to the current estimate of the total costs required to
complete the project:
Percent complete =
Total costs incurred to date
Most recent estimate of
total costs of project
(past and future)
The most recent estimate of total project costs is the sum of the total costs incurred
to date plus the estimated costs yet to be incurred to complete the project. Once the
percentage completed has been computed, the amount of revenue to recognize in the
current period is determined as:
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Current period’s revenue = (Percent complete Total contract revenue)
– Revenue previously recognized
Example
There can be dramatic differences between the revenue and income effects of the completed-contract and percentage-of-completion methods. The completed-contract
method is the simplest and most straightforward and it is discussed first.
To demonstrate the two methods, assume that the Ace Construction Company
has contracted to erect a building for $1.5 million, starting construction on 1
February 20X1, with a planned completion date of 1 August 20X3. Total costs to
complete the contract are estimated at $1.35 million, so the estimated gross profit is
expected to be $150,000. Progress billings payable within 10 days after billing will
be made on a predetermined schedule. Assume that the data shown in the upper portion of Exhibit 6-4 pertain to the three-year construction period. The facts for each
of the three years will be ascertained as each year goes by. That is, in 20X1 the contractor does not know the information that is shown in the columns for 20X2 and
20X3.
The total construction costs were originally estimated at $1,350,000, of which
$350,000 were incurred in 20X1. In 20X2, another $550,000 in costs were incurred,
but the estimated total costs rose by $10,000 in 20X2, to $1,360,000. In 20X3, the
total costs rose by another $5,000, and the total cost to complete the project turns
out to be $1,365,000. Contract profit therefore drops from the original estimate of
$150,000 to an actual amount of $135,000.
As costs are incurred, they are debited to an inventory account called construction in progress. This inventory account is a current asset even for a multi-year project because the operating cycle of the contractor is the length of the longest project
(rather than one year).
Construction companies do not wait until the end of the project to collect their
money. Instead, progress billings are made throughout the duration of the project.
The amount of progress billings is based on the amount of work accomplished to the
date of the billing, as verified by an independent facilitator.
Progress billings are debited to accounts receivable and credited to billings on
contracts, which is subtracted from the construction-in-progress inventory on the balance sheet. If the net of the construction-in-progress inventory (inventory less billings
on contract) results in a debit balance, it is reported as a current asset. This account
balance represents the contractor’s net ownership interest in the construction project;
it is sometimes referred to as the contractor’s draw.
If the net amount in the construction-in-progress inventory is a credit balance, it
represents the developer’s (buyer’s) interest in the project and is referred to as the
developer’s draw. A credit balance is reported as a current liability in the contractor’s
financial statements.
EXAMPLE EXAMPLE EXAMPLE EXAMPLE EXAMPLE EXAMPLE EXAMPLE EXAMPLE EXAMPLE EXAMPLE EXAMPLE EXAMPLE EXAMPLE
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Completed-Contract Method
Under the completed-contract method, there is no recognition of the project in the
income statement until the project is completed and has been legally accepted by the
customer.
The journal entries to record the construction-in-progress inventory, progress
billings, and collections of progress billings for each year for Ace Construction are
shown in the lower portion of Exhibit 6-4.
At the completion of the contact, income is recognized as the difference between
the accumulated credit balance in the billings on contracts account and the debit balance in the construction-in-progress inventory account, assuming that the total price
of the contract has been billed. The accumulated amount of billings on contracts is
recognized as sales revenue, and the accumulated amount of construction-in-progress
inventory on completion of the contract is recognized as cost of goods sold. It is this
series of entries that increases net assets:
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EXHIBIT 6-4
Example of Completed Contract Accounting
ACE CONSTRUCTION COMPANY
Construction Project Fact Sheet
Three-Year Summary Schedule
Contract Price: $1,500,000
1.
2.
3.
4.
5.
6.
7.
8.
20X1
$1,350,000
350,000
350,000
1,000,000
300,000
300,000
270,000
270,000
Estimated total costs for project
Costs incurred during current year
Cumulative costs incurred to date
Estimated costs to complete at year-end
Progress billings during year
Cumulative billings to date
Collections on billings during year
Cumulative collections to date
20X1
20X2
$1,360,000
550,000
900,000
460,000
575,000
875,000
555,000
825,000
20X2
20X3
Construction-in-progress inventory 350,000
550,000
Cash, payables, etc.
350,000
550,000
Accounts receivable
Billings on contracts
300,000
465,000
575,000
Cash
Accounts receivable
270,000
575,000
300,000
465,000
625,000
555,000
270,000
20X3
$1,365,000
465,000
1,365,000
0
625,000
1,500,000
675,000
1,500,000
625,000
675,000
555,000
Billings on contracts
Revenue from long-term contracts
1,500,000
Costs of construction
Construction-in-progress inventory
1,365,000
675,000
1,500,000
1,365,000
On balance sheets during the construction period, the construction-in-progress inventory is reported as total accumulated costs to date less the total progress billings to date.
The completed contract method has the advantage of delaying profit measurement until substantially all of the costs and revenues are known. There may be some
remaining costs that are roughly analogous to warranty costs; these can be estimated
and accrued. Although the costs and revenues are known with a high degree of assurance, the timing of their recognition in the income statement is a matter for some
manipulation. Contractors have been known to informally suggest to customers that
they may want to delay formal acceptance of the project until after the contractor’s
year-end, usually in order to delay taxation. Taxation officials are aware of this practice, however, and often reach into the next year and claim tax on the profits generated on projects “closed” during the first two months of the contractor’s next fiscal
year.
The completed-contract method ranks high on the qualitative characteristic of
objectivity because there is so little estimation involved. On the other hand, the
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method is perceived as lacking in the qualitative attributes of relevance and timeliness
because the benefit of the contractor’s economic activity during the year is not reflected on the income statement as long as the project is under way. Therefore, the completed-contract method is not very helpful if the dominant reporting objective is performance evaluation. The method is very useful for income tax minimization, however, since there is no taxation until the project is complete (even if there may be dispute about which period it was completed in).
Percentage-of-Completion Method
The objective of the percentage-of-completion method is to provide an estimate of the
earnings of the company that will arise as the result of its economic activity (i.e.,
working on construction projects) during the year. Since the contractor spent a lot of
time, effort, and money working on projects in progress, performance evaluation is
better served if periodic profit (or loss) is measured on the basis of effort expended
rather than contracts completed.
Under the percentage-of-completion method, a portion of revenue and expense
(and thus income) is recognized as it is earned in each accounting period. The amount
of income that is recognized is added to the construction-in-progress inventory. By
adding the income earned to date to the inventory, the inventory is, in effect, being
increased to its net realizable value. Total actual income on the contract will not be
known until the project is completed; what is recognized each period is an estimate
of income that is based on many other estimates, as we discuss shortly.
Using the data shown in the upper portion of Exhibit 6-4, the relative proportion
of the total costs that have been incurred to date can be used to determine percentage completed.
Costs incurred to date
Estimated total costs
Percent completed
20X1
$ 350,000
1,350,000
26%
20X2
$ 900,000
1,360,000
66%
20X3
$1,365,000
1,365,000
100%
The percentage completed is computed by dividing the estimate of costs incurred
to date by the estimated total costs. For example, estimated total costs at the end of
20X1 ($1,350,000) equals costs incurred to date ($350,000) plus estimated costs to
complete at the end of 20X1 ($1,000,000). The percentages shown above have been
rounded to the nearest full percentage point. The “exact” percentage for 20X2, to be
precise, is 66.17647...%. But there is no point in calculating the percentage of completion to more than two digits (or, at the most, three). We are working with estimates
here, and it is silly to be “precise” in calculating percentages that are based on
approximations.
The next step is to compute the total amount of revenue recognizable through
each year-end by multiplying the total contract revenue by the percentage completed
for each year:
20X1: $1.5 million 26%
20X2: $1.5 million 66%
20X3: $1.5 million 100%
Less: revenue previously
recognized
Recognized revenue for
the year
20X1
$390,000
—
—
20X2
—
$990,000
—
20X3
—
—
$1,500,000
—
(390,000)
(990,000)
$390,000
$600,000
$ 510,000
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The gross profit to be recognized is the difference between revenue and costs incurred
in the period:
20X1
Revenue for the current
period
Costs incurred in the
current period
Gross profit for the period
$390,000
350,000
$ 40,000
20X2
20X3
$600,000 $ 510,000
550,000
Total
$1,500,000
465,000
1,365,000
45,000
$ 135,000
$ 50,000 $
The journal entries to record the costs incurred on the construction, the progress
billings, and the collections of progress billings are the same as those for the completed-contract method. An additional entry is needed to record the recognition of
revenue and expense each period. The gross profit is debited to the construction-inprogress inventory:
20X1
20X2
20X3
Construction-in-progress
40,000
50,000
45,000
inventory (B/S)
Costs of construction (I/S) 350,000
550,000
465,000
Revenue from long390,000
600,000
510,000
term contracts (I/S)
The construction-in-progress inventory account is greater under the percentageof-completion method than under the completed-contract method by the amount of
gross margin recognized to date. This is the increase in net assets that always accompanies revenue recognition.
Notice that the balance of the construction-in-progress inventory account is not
reduced each year as the revenue and related costs are recognized in the income statement. On the income statement, the recognized gross profit is disaggregated into revenue less costs of construction. The offset to the inventory account is the billings on
contracts account, just as for the completed-contract method.
When the project is completed, the billings on contracts will completely offset the
construction-in-progress inventory. A journal entry is needed to remove both
accounts from the books of Ace Construction:
Billings on contracts
Construction-in-progress inventory
1,500,000
1,500,000
Comparison of Results
Exhibit 6-5 compares the financial statement presentations for the completedcontract method and the percentage-of-completion method. Under the completedcontract method, inventory is carried at cost. Under the percentage-of-completion
method, inventory is carried at cost plus recognized gross profit.
The difference between year-end inventory amounts under the two methods is the
accumulated gross margin recognized under the percentage-of-completion method.
Exhibit 6-5 also shows the dramatic difference in gross profit between the two methods
on a year-to-year basis. However, total gross profit over the three years is the same for
each method. This is another of the allocation games of which accountants are so fond.
Accounting for Losses on Long-Term Contracts
When the costs necessary to complete a contract result in losses, two situations are possible:
1. The loss results in an unprofitable contract. In this situation, the loss is recognized
in full in the year it becomes estimable. For example, assume that, at the end of
20X2, Ace’s costs incurred are as shown ($350,000 in 20X1 and $550,000 in
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EXHIBIT 6-5
Financial Statement Presentation of
Accounting for Long-Term Construction Contracts
COMPLETED-CONTRACT METHOD
20X1
Balance Sheet:
Current Assets:
Accounts Receivable
Inventory:
Construction in progress
Less: Billings on contracts
Construction in progress in excess of billings
Income Statement:
Revenue from long-term contracts
Costs of construction
20X2
20X3
$ 30,000
$ 50,000
350,000
300,000
900,000
875,000
50,000
25,000
$0
0
$0
0
$1,500,000
1,365,000
0
0
135,000
Gross profit
Note 1: Summary of significant accounting policies.
Long-term construction contracts. revenues and income from long-term construction contracts
are recognized under the completed-contract method. Such contracts are generally for a duration in excess of one year. Construction costs and progress billings are accumulated during the
periods of construction. Only when the project is completed are revenue, expense, and income
recognized on the project.
PERCENTAGE-OF-COMPLETION METHOD
Balance Sheet:
Current Assets:
Accounts Receivable
Inventory:
Construction in progress
Less: Billings on contracts
Construction in progress in excess of billings
Income Statement:
Revenue from long-term contracts
Costs of construction
Gross Profit
20X1
20X2
20X3
$ 30,000
$ 50,000
390,000
300,000
990,000
875,000
90,000
115,000
$390,000
350,000
$600,000
550,000
$510,000
465,000
40,000
50,000
45,000
Note 1: Summary of significant accounting policies.
Long-term construction contracts. Revenues and income from long-term construction contracts are recognized under the percentage-of-completion method. Such contracts are generally for a duration in excess of one year. Construction costs and progress billings are accumulated during the periods of construction. The amount of revenue recognized each year is based
on the ratio of the costs incurred to the estimated total costs of completion of the construction
contract.
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20X2), but the estimate of the costs to complete the contract in 20X3 increases
to $625,000 from $465,000, an increase of $160,000.
Since costs incurred through 20X2 total $900,000, the total estimated cost
of the contract becomes $1,525,000 (instead of $1,365,000), and there is now an
expected loss on the contract of $25,000.
The $25,000 loss would be recognized in 20X2 under both methods of accounting for long-term construction contracts. A simple accrual entry is made for the
completed-contract method, and the percentage-of-completion would record a
gross loss of $65,000 ($25,000 + $40,000), which records the loss and reverses
the profit recorded in prior years.
2. The contract remains profitable, but there is a current-year loss. Suppose Ace’s costs
incurred to the end of 20X2 are as shown, but the estimate to complete the contract has increased to $550,000. Total costs of $900,000 have already been
incurred; thus, the total estimated cost of completing the contract has risen to
$1,450,000. The contract will still generate a gross margin of $50,000.
Under the completed-contract method, all items are deferred until 20X3, and no
entry is needed in 20X2. For the percentage-of-completion method, the 20X2 completion percentage is reworked (now 62%; $900,000 ÷ $1,450,000). This decreases
the amount of revenue that will be reported, and results in a reported gross loss in
20X2.
Estimating Costs and Revenues
It is important to understand the extent of the estimates and approximations that
underlie the percentage-of-completion method. Obviously, the cost to complete is an
estimate. It may be wildly off the mark, because large scale projects are often begun
before the final design is even completed.
A six-week television series produced by PBS titled “Skyscraper” showed the
progress on construction of a Manhattan office building from design to final acceptance. One point made early in the show was that the developer couldn’t wait until
the building’s design was fully developed before beginning construction; there was
just too much potential revenue to be lost by waiting another year or so to completely
finish all of the details. The old cliché is that “time is money,” and nowhere is this
adage truer than in real property development. Therefore, estimates of “cost to complete” are informed judgements, but they can change radically over the course of the
contract.
As well, the “costs incurred to date” is an estimate! How much of the contractor’s overhead is to be included in the costs assigned to the project, and how much is
charged as a period cost? What proportion of purchased and/or contracted materials
should be included in cost to date? If the contractor has ordered and had delivered
5,000 tons of bricks for exterior sheathing, should the cost of those bricks be included in the cost to date when the bricks are purchased or should the cost be excluded
until the bricks are actually used in construction of the building?
Finally, a commonly overlooked estimate is that of the revenue. True, any longterm construction contract starts out with a contract price, but the initial price hardly ever ends up being the real revenue figure. Indeed, contractors often bid on jobs at
zero profit or even at a loss in order to get the job. The reason is that every construction job involves change orders, which is a change in the original design of the
building (or of whatever is being constructed). Change orders require additional revenue, and the contractor often bids low on the original contract because he knows
that he will make his money on the change orders (which can hardly be submitted to
a competitive bidding process!). So, in the course of a construction project
•
•
•
the estimated cost to complete will change each period;
the cost incurred in the current period (to be used in the percentage calculation)
is an estimate; and
the estimated total revenue will change from period to period.
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It is safe to say that the percentage-of-completion method is an approximation! It represents a trade-off between conflicting qualitative criteria; objectivity is sacrificed for
timeliness and relevance.
PROPORTIONAL PERFORMANCE METHOD FOR SERVICE COMPANIES
The proportional performance method is used to recognize service revenue that is
earned by more than a single act, when the service extends beyond one accounting
period. In fact, recording interest revenue or rental revenue as time passes are really
applications of proportional performance methods. Revenue is recognized based on
the proportional performance of each act.
The proportional performance method of accounting for service revenue is similar to the percentage-of-completion method and has to meet the same criteria as a
long-term construction contract:
•
•
•
a fixed price contract with reasonable assurance of collection,
a way to measure extent of performance, and
an ability to estimate the remaining costs to completion.
Many service contracts are subject to at least as many uncertainties as are construction contracts. In particular, it is not unusual for the revenue to change as the client
changes the scope of the assignment or the specifications of the task. Software contracts, for example, can double or triple in price if the client keeps changing his mind
about what he wants the software to do.
Proportional measurement takes different forms depending on the type of service
transaction:
1. Similar performance acts. An equal amount of service revenue is recognized for
each such act (for example, processing of monthly mortgage payments by a mortgage banker).
2. Dissimilar performance acts. Service revenue is recognized in proportion to the sell-
er’s direct costs to perform each act (for example, providing examinations, and
grading by a correspondence school). If the direct cost of each act cannot be measured reliably, the total service sales revenue should be prorated to the various acts
by the relative sales value method. If sales value cannot be identified with each act,
the straight-line method to measure proportional performance can be used.
3. Similar acts with a fixed period for performance. Service revenue is allocated and
recognized by the straight-line method over the fixed period, unless another allocation method is more appropriate (for example, providing maintenance services
on equipment for a fixed periodic fee).
CHOOSING A REVENUE RECOGNITION POLICY
This chapter has illustrated many different ways in which revenue can be recognized.
Revenue recognition is the most pervasive and most difficult single accounting policy choice that many companies must face. With such a plentiful supply of alternatives, how can a company choose an appropriate policy?
Although there are many theoretical alternatives, the choice of policy is not a free
game. The revenue recognition policy is, first and foremost, a function of the revenuegenerating activity of the enterprise. When there is more than one revenue-generating
activity, then there may be a different policy for each. For example, a retail company
that engages in straightforward sales activity for cash or credit will probably recognize
sales revenue at the point of delivery, while for interest revenue on its outstanding credit card balances the company will likely recognize interest revenue as time elapses.
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A chosen revenue recognition policy must satisfy the general recognition criteria
of measurability and probability. Revenue must be measurable with reasonable assurance, and its eventual realization (in cash) must be highly probable. It is important to
bear in mind that the act of revenue recognition increases the net assets of the company. The increase may be through an increase in cash, accounts receivable, or inventories, but ultimately the amount must be realizable in cash.
Measurability and probability are essential requirements for revenue recognition,
but those are relative terms. There is a trade-off between those two qualitative characteristics and those of relevance and timeliness. The earlier revenue is recognized, the
more difficult it is to measure and the less certain it is of eventual realization. But the
later revenue is recognized, the less useful it is for predicting cash flows and for evaluating management’s performance.
Often, there are several different points in a single revenue-generating activity at
which revenue can be recognized. This is especially true if the activity involves a sustained effort to earn the revenue or to collect it. The choice of revenue recognition
policies depends very heavily on the financial reporting objectives of the company
and on the motivations of its managers. An objective of income tax minimization will
lead to a much different revenue recognition policy than will an objective of maximizing net income. Revenue recognition policy is, very often, the supreme test of an
accountant’s professional judgement.
CONCEPT
REVIEW
1. What qualitative characteristics are better served by completed-contract reporting than by percentage-of-completion reporting?
2. Which financial reporting objectives are satisfied more by the percentage-of-completion method than by the completed-contract method?
3. What estimates are required in order to use the percentage-of-completion
method?
4. How does the construction-in-progress inventory balance differ between the percentage-of-completion method and the completed-contract method?
RECOGNITION OF GAINS AND LOSSES
Gains and losses are distinguished from revenues and expenses in that they usually
result from peripheral or incidental transactions, events, or circumstances. Whether
an item is a gain or loss or an ordinary revenue or expense depends in part on the
reporting company’s primary activities or businesses.
For example, when a company that is primarily involved in manufacturing and
marketing products sells some of its land, the transaction is accounted for as a net
gain or loss because this is not the primary business of the company. When a real
estate sales company sells land, however, the transaction gives rise to revenues and
expenses.
A gain or loss may result from purely internal transactions, such as a write-down
related to a plant closing. Such gains and losses are also recognized in the period
when the transaction occurs and are shown net.
Most gains and losses are recognized when the transaction is completed. Thus,
gains and losses from disposal of operational assets, sale of investments, and early
extinguishment of debt are recognized only when the final transaction is recorded.
However, estimated losses are recognized before their ultimate realization if they both
(1) are probable and (2) can reasonably be estimated.
Examples are losses on disposal of a segment of the business, pending litigation,
and expropriation of assets. If both conditions are not met, the nature and possible
amount of the possible loss must be disclosed in a note to the financial statements. In
contrast, gains are almost never recognized before the completion of a transaction
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that establishes the existence and amount of the gain. A gain should be recognized
only when realized, except as explained in the following paragraph. This reflects an
appropriate degree of skepticism.
There are circumstances in which gains and losses are recognized when there has
been a change in value rather than a transaction. This happens when inventory items
are reported at market value instead of cost. Examples of such inventory items
include
• Commodities that are carried at market value. If a company produces commodities that are readily saleable on an open public market or to a marketing board,
as described above for recognition prior to delivery, the act of revenue recognition means that the inventories are revalued from the cost of production to their
market price. If the company holds the inventory from one period to another,
changes in market value are recognized as gains or losses for the period.
Examples include farm products (e.g., hogs, cattle, wheat, eggs) and many natural resources (e.g., gold, silver, copper, oil).
• Marketable securities held by a financial institution. Securities dealers must
report their inventory of securities held for sale at market. Investment companies
(such as mutual funds) must carry their investment portfolio at market value so
that investors can be informed of the net asset value of the company’s holdings.
Banks must carry the securities held in their trading account at market value. Life
insurance companies report their investments on a five-year moving average of
market prices. Companies such as these will recognize gains or losses on their
investment portfolios. In some industries the realized gains and losses are segregated from the unrealized, but both realized and unrealized are recognized.
It should be noted that changes in the market value of these types of items are referred
to as gains and losses even though they are a part of the normal business activities of
the enterprise. There is nothing peripheral about gains and losses on securities held
by a bank!
Losses may also be recognized when the recoverable value of an asset falls below
its historical cost. Common examples are inventory (discussed in Chapter 9), capital
assets (discussed in Chapter 11), and long-term investments (discussed in Chapter 12).
REVENUE ON THE CASH FLOW STATEMENT
This chapter discussed the concept that economic revenue grows or is earned over
time — sometimes in a brief time span, but often over quite a long period of time.
Accounting, on the other hand, tends to recognize revenue at a particular point in a
more continuous earning cycle. On occasion, revenue recognition also coincides with
the cash inflow, but that circumstance is quite rare. Usually, a company recognizes
revenue prior to receiving the cash. Cash flow seldom coincides with revenue recognition.
In order to report cash flow from operations, the accruals relating to revenue
recognition must be removed. The primary adjustments are
•
•
•
Any increase in accounts receivable or notes receivable from customers must be
deducted from net income (or from revenue); a decrease in receivables would be
added.
Expenses that are recorded in order to achieve matching must similarly be added
back to net income (or deducted from total operating expenses, if the direct
method is used); examples include warranty provisions and bad debt expense.
Unearned revenue must be added to revenue; the cash has been received but revenue has not yet been recognized.
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Revenue can be recognized only if the cash flow is highly probable. The reporting
problem is that revenue recognition and cash flow often do not occur in the same
accounting period.
DISCLOSURE
The choice of revenue recognition method can have enormous impact on a company’s reported earnings. As we have seen, most methods require some accounting estimates, and some methods require a great deal of estimation.
The CICA Handbook contains no explicit requirement for disclosure of revenue
recognition policies, except for the general requirement that a company disclose its
policies when there is a choice of policy. In practice, less than half of public companies seem to disclose their revenue recognition policies.11
A good example of detailed disclosure is that of Western Star Truck Holdings Inc.:
Revenue from the sale of trucks is recognized when ownership is transferred. Revenue from the sale of manufactured buses is recognized on
a percentage of completion method, applied on the basis of defined
milestones. Provisions are made for anticipated losses, if any, as soon
as they become evident. Unbilled revenue represents revenue that has
been recorded under the percentage of completion method but has not
yet been invoiced to the customer. Revenue from sales of after-market
parts is recognized upon shipment to customers.
Other disclosures are less informative. Cara Operations reports its revenue
recognition policies as follows:
Income on the sale of franchises is recognized when it is considered
earned. Revenues from services are recognized as services are rendered.
This note leaves an important question hanging: when does the company consider
franchise revenue (e.g., Swiss Chalet; Harveys) as having been earned?
An example of a company that is silent on its revenue recognition policies is The
Molson Companies. Molson’s has significant business interests in brewing (Molson;
Coors; Foster’s), sports (Montreal Canadiens; the Molson Centre, Montreal), and
retailing (Home Depot; Beaver Lumber). A reader of the financial statements might
think that there are significant revenue recognition issues surrounding some of these
businesses, but the company presents no information regarding revenue recognition.
CONCEPT
REVIEW
1. What basic recognition criteria must be satisfied before a particular revenue
recognition policy can be used?
2. What is the relationship between revenue recognition and a company’s net asset
value?
3. When there is more than one feasible revenue recognition policy that a company
could use for a revenue-generating activity, how is a single policy chosen from the
feasible set of policies?
4. When might a company recognize a gain due to an event rather than a transaction?
5. What adjustments must be made to revenue when the cash flow statement is
prepared?
11 Financial Reporting in Canada 1997, p. 56.
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Summary of Key Points
SUMMARY
OF
CHAPTER 6
KEY POINTS
1. For most companies, the earnings process is continuous. That is, the profit-directed
activities of the company continually generate inflows or enhancements of the
assets of the company.
2. Revenue recognition policies must be chosen carefully because of their profound
effect on key financial results.
3. Before the results of the earnings process are recognized in the accounting
records, revenue must meet the recognition criteria of probability and measurability. Revenue must also be earned, and realized or realizable.
4. A sale transaction is usually measured at the sales invoice price. When there are
long-term, interest-free payment terms, discounting may be appropriate.
5. Barter transactions are typically recognized at the value of the asset or service
given in the exchange.
6. Revenue can be recognized at a critical event or on the basis of effort expended.
Critical events can be delivery, prior to delivery (e.g., on production, if there are
no uncertainties regarding the sale transaction), or after delivery (if there are significant uncertainties about measurement, collection, or remaining costs).
Delivery is the normal critical event that triggers revenue recognition.
7. The recognition of revenue results in an increase in net assets, which is recognized
at the critical event. Costs incurred prior to the critical event are deferred. When
revenue is recognized, deferred costs are expensed, and future costs are accrued.
8. The instalment sales method of revenue recognition delays recognition of gross
profit until cash is collected.
9. The cost recovery method is a conservative method in which no profit is recognized until all costs associated with the sale item have been recovered in cash. All
subsequent cash collections are profit.
10. Long-term contracts can be accounted for using the percentage-of-completion
method, or the completed-contract method. If a long-term, fixed-price contract
with a creditworthy customer is accompanied by reasonably reliable estimates of
(a) cost to complete and (b) percentage of completion, based either on output or
input, percentage-of-completion is appropriate.
11. Under the completed-contract method, revenues and expenses are recognized
when the contract obligations are completed. Costs incurred in completing the
contract are accrued in an inventory account, and any progress billings are
accrued in a contra-inventory account.
12. Long-term contracts are often accounted for on the basis of effort expended.
Under the percentage-of-completion method, revenues and expenses are recognized each accounting period based on an estimate of the percentage of completion. Costs incurred in completing the contract and recognized gross profit are
accrued in an inventory account.
13. Revenue recognition policies are chosen in accordance with the financial reporting objectives of the enterprise, constrained by the general recognition criteria of
probability and measurability. The choice of a revenue recognition policy
involves a trade-off between qualitative criteria, such as between verifiability and
timeliness.
14. Cash flow from operations must be computed by adjusting revenue (or net
income) for changes in accounts and notes receivable, for changes in unearned
revenue, and for accrued expenses that do not represent cash expenditures during the period.
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REVIEW PROBLEM
Precision Punctual Construction Company has agreed to build a 10-storey office
building for Mountain Bank Limited. The contract calls for a contract price of
$15,000,000 for the building, with progress payments being made by Mountain as
the construction proceeds. The period of construction is estimated to be 30 months.
The contract is signed on 1 February 20X5, and construction begins immediately.
The building is completed and turned over to Mountain Bank on 1 December 20X7.
Data on cost incurred, estimated costs to complete, progress billings, and
progress payments over the period of construction are as follows:
20X5
Costs incurred this period
$ 1,500
Costs incurred to date
1,500
Estimated costs to complete at year-end 10,500
Estimated total costs of project
12,000
Progress billings this period
1,200
Progress payments received this period
825
($ thousands)
20X6
$ 7,875
9,375
3,125
12,500
6,000
6,300
20X7
$ 3,825
13,200
0
13,200
7,800
7,875
Required:
1. Show the entries to account for this project over the period of construction,
assuming that PPC uses
a. the completed-contract method of recognizing revenue.
b. the percentage-of-completion method of recognizing revenue
2. Show the relevant balance sheet and income statement items for 20X5, 20X6,
and 20X7 for PPC, assuming that the company uses
a. the completed contract method.
b. the percentage-of-completion method.
REVIEW PROBLEM — SOLUTION
1 and 2: The entries to record the construction of the building for both the completedcontract method and the percentage-of-completion method are as follows (in
$ thousands):
Entries for 20X5:
Completedcontract
method
a. To record incurrence of construction
costs:
Construction-in-progress inventory
Cash, payables, etc.
b. To record progress billings:
Accounts receivable
Billings on contract
c. To record billing collections:
Cash
Accounts receivable
270
1,500
Percentage-ofcompletion
method
1,500
1,500
1,200
1,500
1,200
1,200
825
1,200
825
825
d. To recognize revenue for percentage
of completion:*
Construction-in-progress inventory
Cost of construction
Revenue from long-term contract
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825
375
1,500
1,875
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Review Problem — Solution
* The percentage of completion is the cost incurred to date divided by total estimated project costs, or $1,500 ÷ $12,000 = 12.5%. The total amount of revenue
recognizable to this point is $15,000 12.5% = $1,875.
Entries for 20X6:
Completedcontract
method
a. To record incurrence of
construction costs:
Construction-in-progress
inventory
Cash, payables, etc.
7,875
Percentage-ofcompletion
method
7,875
7,875
b. To record progress billings:
Accounts receivable
Billings on contract
6,000
c. To record billing collections:
Cash
Accounts receivable
6,300
7,875
6,000
6,000
6,000
6,300
6,300
d. To recognize revenue for
percentage of completion:*
Construction-in-progress inventory
Cost of construction
Revenue from long-term contract
6,300
1,500
7,875
9,375
* The percentage of completion is the cost incurred to date divided by total estimated project costs, or $9,375 ÷ $12,500 = 75%. The total amount of revenue
recognizable to this point is $15,000 75% = $11,250. Since $1,875 was recognized in 20X5, the amount recognizable in 20X6 is $11,250 – $1,875 = $9,375.
Entries for 20X7:
Completedcontract
method
a. To record incurrence of
construction costs:
Construction-in-progress
inventory
Cash, payables, etc.
3,825
Percentage-ofcompletion
method
3,825
3,825
b. To record progress billings:
Accounts receivable
Billings on contract
7,800
c. To record billing collections:
Cash
Accounts receivable
7,875
3,825
7,800
7,800
7,800
7,875
7,875
d. To recognize revenue for
percentage of completion:*
Cost of construction
Revenue from long-term contract
Construction-in-progress inventory
7,875
3,825
3,750
75
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* The project is completed; any remaining portion of the contract price not previously recognized as revenue should be recognized this period. In prior years,
$1,875 $9,375 = $11,250 was recognized, thus $3,750 (i.e., $15,000 –
$11,250) is recognized in 20X7.
e. To record elimination of contract
costs from inventory:
Billings on contract
Construction-in-progress
inventory
f.
15,000
15,000
To recognize revenue for
completed contract:
Billings on contract
15,000
Cost of earned construction revenue 13,200
Revenue from long-term contracts
Construction-in-progress inventory
31 Dec. 20X5
Completed
contract
Percentage
of
completion
15,000
13,200
31 Dec. 20X6
Completed
contract
Percentage
of
completion
Balance sheet:
Accounts receivable
$ 375 $ 375 $
75 $
75
Inventory:
Construction in progress
$1,500 $1,875 $9,375 $11,250
Less: Billings on contract
(1,200) (1,200) (7,200) (7,200)
Construction in progress in
excess of billings
$ 300 $ 675 $2,175 $ 4,050
31 Dec. 20X7
Completed
contract
Percentage
of
completion
0
0
0
0
0
0
0
0
Income statement:
Revenue from long-term
contracts
Cost of construction
$ ------$ -------
$1,875
(1,500)
$ ------$ -------
$ 9,375 $15,000 $3,750
(7,875) (13,200) (3,825)
Gross profit
$ -------
$ 375
$ -------
$ 1,500 $ 1,800
$
(75)*
* This is an example of a current year loss on a contract that is profitable overall.
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Questions
CHAPTER 6
QUESTIONS
6-1
6-2
6-3
6-4
6-5
6-6
6-7
6-8
6-9
6-10
6-11
6-12
6-13
6-14
6-15
6-16
6-17
6-18
6-19
6-20
Explain the relation between the definition of revenue and the definitions of
assets and liabilities.
When is revenue earned in economic terms? How does this relate to typical
accounting revenue recognition?
What impact do individual corporate reporting objectives have on revenue
recognition policies?
What are the fundamental criteria for recognition of any element in the financial statements? Explain the additional criteria that revenue must meet before
being recognized.
What do the terms “realization” and “earned” mean in the context of revenue recognition?
Give two typical examples of revenues for which recognition occurs on the
basis of the passage of time.
How is revenue measured in a barter transaction?
What is meant by revenue recognition at a critical event? Give examples of
several critical events.
Why is revenue typically recognized on delivery?
Under what circumstances is revenue recognized at a critical event before
delivery? After delivery?
Explain how a net asset increase is triggered by appropriate entries at the
point of revenue recognition.
Why might a franchisor have to delay revenue recognition past the point in
time at which the franchisee takes control of their franchise operation?
What is a consignment? How is revenue recognized on a consignment transaction?
What conditions must be met in order for revenue to be recognized when a
customer has the right to return purchased products? What accounting procedures are used until all conditions are met?
Describe the instalment sales method of recognizing revenue and when it is
appropriately used.
Describe the cost recovery method of recognizing revenue. When is it appropriate?
Identify and explain two different approaches for determining the extent of
progress toward completion of a construction project.
Why is the ending inventory of construction in progress different in amount
when the percentage-of-completion method is used compared with the completed-contract method? Explain the amount of the difference.
When a loss is projected on an unprofitable long-term construction contract,
in what period(s) is the loss recognized under (a) percentage-of-completion
and (b) completed contract methods?
Under what circumstances do gains and losses reflect changes in value, rather
than realized transactions?
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CASE 6-1
CASES
John and Mike
John and Mike set up a partnership early this year in order to speculate in real estate.
They specialize in the acquisition of small, run-down apartment buildings, which they
then renovate, rent out to improve occupancy rates, and resell. Mike works at this
enterprise full-time, overseeing the renovation and rental process. John continues to
work at a full-time salaried job in an unrelated business.
Annual profits are allocated as follows:
1. “Salary” of $50,000 to Mike
2. Interest to both partners of 10% per annum, based on monthly average capital
balances
3. Remainder equally.
The partners have agreed on a schedule of monthly drawings, to be charged against
each partner’s capital accounts. Drawings may not exceed profit allocations.
In their first year, the partners successfully “flipped” three apartment buildings,
and owned four more at year-end, awaiting resale. It is now the end of their first year,
and accounting policies have yet to be finalized. The following are areas of contention:
1. Revenue recognition, rental income
Mike has proposed that revenue be recognized as rent is collected from tenants. John
has proposed that rent revenue be recognized on the first day of the month, when it
is due, whether collected or not. Typically, most rent is collected within a week, but
there are always some problem tenants, especially in newly-bought buildings, which
need extensive renovations and often have undesirable tenants.
2. Depreciation policy, rental buildings
John reasons that rental buildings are all for resale, and are thus “inventory.” As
such, he claims that no depreciation should be charged as long as net book value is
less than market value. Mike is not convinced that this reasoning is valid, as he thinks
depreciation is always incurred and must be recorded.
3. Revenue recognition, building sale
Often, there is a time lag between the sale of a building (that is, the date upon which
the sale agreement is signed), the date on which title passes, and the date that the
partnership receives all the sale proceeds. For example, in a recent sale, the agreement
was signed on 1 November, and title passed on 15 December, at which time half of
the proceeds were paid. The other half is due on 15 December in three years’ time,
with accrued interest, since the partnership took back a long-term note as part of the
sale financing. John favours revenue recognition when the sale agreement is signed;
Mike prefers to wait until the cash is collected.
Both partners have agreed that statements will primarily be used for profit allocation
and need not necessarily follow GAAP. They are more concerned about cash flow,
and in particular, making sure there is enough cash flow for partner’s withdrawals.
Required:
Analyze the issues and present your recommendations to the partnership.
[CGA-Canada, adapted]
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CASE 6-2
Tempus Fugit
Tempus Fugit is a large conglomerate of 30 subsidiary companies with plants and
branches throughout the world. The company has been in the business of manufacturing and distributing clocks, watches, and other timepieces for over 50 years.
Recently, the company experienced a change in management when the original
founder retired and sold his controlling interest.
On 1 May 20X5, Smith & Smith, a publicly-traded international consulting firm,
was awarded the contract to design and install a computerized management information system in each of Tempus Fugit’s subsidiaries. The project was projected to
take four years to complete. Michael Smith, the founder and managing partner of
Smith & Smith, and his staff, worked exclusively on this project from May to
October. Currently, one-half of the company’s workforce is working on the job. Smith
& Smith obtained this project after submitting a bid on 1 March 20X5, which took
most of February to prepare; the bid price was $45,000,000.
It is January 20X6, and annual financial statements for Smith & Smith are being
prepared. Michael Smith has come to you, the controller of the company, to discuss
how the contract will be reported. He is anxious to present the contract as favourably
as possible under the limitations of GAAP. His comments to you are:
“I know this is the first long-term contract that we have entered into, and I have
heard that we can recognize revenue based on the percentage of the project that is
complete. That percentage should be based on management’s best estimates, as are so
many things under GAAP. In my opinion, even though we are behind in the installation, we should recognize revenue according to the percentage that we estimated
would be done in our contract bid. If we don’t, Tempus Fugit’s management will be
on our backs, wondering what is going on and slowing us down even more. I sure
don’t need that with all of the problems we are experiencing on this project!”
You ask Smith about the problems that are being experienced on the project. He
responds that they are of a highly technical nature. He urges you to complete the
financial statements as soon as possible, since Smith & Smith is experiencing a cash
flow shortage and Tempus Fugit will not release the first payment on the contract
until the year-end statements have been received.
You are aware of the following facts about Smith & Smith and Tempus Fugit:
•
•
•
•
Smith & Smith has been in business for five years. This is the first time the company has landed a contract of this magnitude. Previous contracts have all been
completed within a one-year time frame.
The contract provides for Tempus Fugit to pay in four equal annual instalments
on receipt of audited statements from Smith & Smith. One-quarter of the project
should be completed each year.
Much of the contract involves design and testing of computer programs, and it is
difficult to determine the degree of completion of the project at any time. Few
external experts in the area exist, since Smith & Smith is in a new industry and a
specialized field. The company has never been too concerned about estimating
completion before because all of its contracts have been short-term.
The auditor has no way of determining the percentage of completion of the project, since the work is so subjective. Because the same audit firm has been engaged
by Smith & Smith for the past five years and has found the partners to be reputable, the auditor is generally able to rely on management’s best estimates.
After your conversation with Michael Smith, you find yourself in the coffee room
with Rachel Harris, the chief programmer on the Tempus Fugit project. You have
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always had a good relationship with Rachel since you share a common interest in
show dogs. Out of curiosity, you ask her how much of the project she believes is done
and about the problems the company is experiencing. Her response is:
“You know, the partners bid on this one to get us into the big leagues, and let me tell
you, the big leagues are tough! We have never handled a project this large, and it is
taking us a lot longer to get some of the basic systems developed than we ever imagined. Although it’s hard to tell, I would say we are only about 10% done at this time.
We are in the process of hiring more staff and establishing supplier relationships, and
all of this takes time. I am still confident that we will complete the project in four
years, but I don’t think we will catch up to our original estimates until the third year.
By then, the staff will be trained and we will be much more effective.”
After coffee, you run into Michael Smith again. He asks that you meet him in his
office Monday morning, ready to discuss the accounting options available for the
project and your recommended accounting treatment. He is rushing out the door to
a meeting with the banker, who called with some concerns about the company’s cash
flow problems.
Required:
Identify and analyze the alternative treatments available to account for the timing of
the revenues and expenses that will be recognized in the contract with Tempus Fugit.
What are the ethical issues you must consider before making your recommendation
to Michael Smith? What should you say during the Monday morning meeting with
Smith?
[CGA-Canada, adapted]
CASE 6-3
Kryton Corporation
Kryton Corporation is a property development company, with expertise in larger,
multiple-unit apartment buildings. Kryton must comply with GAAP to satisfy bank
lenders who provide project and working capital financing. Typically, the company
finds a site, arranges for interim and mortgage financing, and then constructs the
building through subcontractors. As the building is being built, Kryton looks for an
investor to take over ownership of the building; often life insurance companies are
interested, as are individuals through limited partnerships. Kryton has a property
management division that runs such large apartment buildings.
It is now the end of 20X3, and their latest project, a 255-unit apartment building, has been harder to sell. A deal is finally in place. An agreement has been signed
with a group of individual investors, who have formed a limited partnership. When
the project is completed, in July 20X5, the building will be sold to the partners, who
will pay Kryton as follows:
Cash, provided by first mortgage from Confidential Insurance
Cash, payments by the partners to Kryton
4% notes receivable to Kryton from the investors, payable
in four equal instalments on the anniversary of
the turnover date
Five-year, 18% second mortgage provided by Kryton
$11,000,000
1,000,000
2,000,000
1,500,000
$15,500,000
The estimated costs of the project are $12,300,000, of which $6,500,000 have been
incurred to the end of 20X3. Kryton intends to record the profit ($3,200,000) in July
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20X5, when the building is completed. The assets received in consideration (listed
above) would be recorded at that time. Further details on the purchase agreement are
below.
Required:
Explain how Kryton should recognize revenue for the project.
KRYTON CORPORATION LTD.
Information on Purchase Agreement
The project differs from previous projects in both the manner of financing and in the number of indemnities and covenants that Kryton must provide. The turnover date, referred to
below, is the date that the partnership assumes ownership of the project. It occurs when
the project is 90% leased to occupants. Extracts from the offering memorandum:
Kryton second mortgage
The Kryton second mortgage will be in the principal amount of $1.5 million and will
bear interest at the rate of 18% after the turnover date.
The mortgage will include the following terms:
1. The mortgage will be without recourse to the partners’ personal assets.
2. Payments of principal and accrued interest at the maturity date are required only to the
extent that proceeds are available from the refinancing of the first mortgage; the second
mortgage is to be renewed for any unpaid balance for a further term, without interest.
3. The partnership will have the right to set off any amount owing by it under the
second mortgage agreement against amounts by which Kryton is in default under
the cash flow guarantee (see below).
Initial leasing period indemnity
The agreement provides that Kryton will operate the project on behalf of the partnership and will indemnify the partnership for all losses incurred in operating the project during the initial leasing period which ends on the turnover date.
Cash flow guarantee
Kryton has agreed to provide interest-free loans to the partnership for the following
purposes:
1. To fund, as required, for a period of 10 years from the turnover date, the amount,
if any, by which the total operating expenses of the project (including payments
on account of principal and interest due on the first mortgage, but excluding noncash items such as depreciation and reserves for replacement of equipment and
chattels) exceed the aggregate gross income receipts from the project.
2. To fund, during the period commencing on the turnover date and ending on 31
December 20X5, the amount (the “Guaranteed Amount”), if any, by which the
actual net cash flow is less than the Kryton-prepared forecast of net cash flow
(this forecast is not reproduced here).
Management of the project
Kryton will be appointed manager of the project for a term of 10 years, and will be paid
5% of monthly gross cash receipts. Kryton will be responsible for the ongoing leasing
of apartment units comprising the project, maintenance and repairs, collection of rents,
payment of all expenses properly incurred in connection with such duties out of revenues received from the project including all amounts payable under the mortgages, the
maintenance of fire and liability insurance on the project, the preparation of a cash
budget for each year, and the annual remittance of cash surpluses to the partners.
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CASE 6-4
Acme Construction Ltd.
Bob Bothwell had started Acme Construction Ltd. early in 20X2 after working for
several years as a supervisor for a local construction company. An inheritance from
his parents had provided the start-up capital. Bob’s wife, Susan, did all of the bookkeeping on weekends without pay to help conserve cash.
For the 20X2 and 20X3 year-ends, the firm, where you are employed as a student-in-accounts, had performed a review of the financial statements and prepared
the tax returns for the company. In late December 20X4, Bob Bothwell phoned the
partner in charge of the engagement to arrange a meeting in Bob’s office on 30
December 20X4.
The partner asked George Cathcart, the senior field auditor on the engagement
in 20X2 and 20X3, to represent him at the meeting and asked that you accompany
George.
At the meeting, Bob explained that business was booming, and that he was considering privately raising additional equity capital to undertake some very large projects. He wanted to retain control of the company but was willing to relinquish sole
ownership instead of increasing his bank loan. However, the preliminary draft statements for 20X4 did not look as impressive as he had expected.
He handed George and you a copy of the income statement (Exhibit 1), along
with a summary of contracts undertaken (Exhibit 2). He shook his head and said, “I
didn’t bring the balance sheet because I don’t think it is correct. The materials in
inventory are worth $200,000 now, not the $150,000 I paid for them. The same thing
applies to the temporary investments. My broker assures me that they are worth
twice what I paid. I also don’t see anything reflected in the financial statements about
the lawsuit that I’m involved in. My lawyer says that, when we go to court next week,
I’ll be sure to win $27,000 from the subcontractor that delayed the curling rink project.”
“My biggest problem is with the income figure,” he continued. “I don’t seem to
get credit for the projects that are in progress, even though my costs are usually in
line, and I know I’m making money. Is there any way to improve my net income without paying any additional income tax?”
Required:
Prepare a memo to George Cathcart. The memo is to include a revised net income figure for both 20X4 and 20X3 assuming that the company changes its revenue recognition policy from completed-contract to percentage-of-completion, but continues to
calculate taxes on the completed-contract basis. You should also include your
thoughts on the best way to deal with the problems Bob raised. Cathcart will be using
your work as a basis for his report to the partner.
[ICAO, adapted]
EXHIBIT 1
ACME CONSTRUCTION LTD.
Income Statement (draft)
for the year ended 31 December
20X4
Net revenue from completed contracts
General and administrative expenses
Income before taxes
Income taxes
Net income for the year
278
20X3
$365,000
172,000
$136,000
100,000
193,000
48,250
36,000
9,000
$144,750
$ 27,000
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Significant Accounting Policies
Revenue recognition: the company follows the completed contract method of recognizing revenue from construction projects.
EXHIBIT 2
ACME CONSTRUCTION LTD.
Summary of Contracts Undertaken
Started in 20X2
Mainline Apartments
The contract price was $600,000, and costs were estimated at $450,000. The project
was one-half completed at the end of 20X2, and costs were on target at $225,000. In
20X3, the project was completed but costs were $14,000 higher than estimated. The
customer was billed $600,000 and all but $90,000 was received in 20x3. The balance
was collected in 20X4.
Started in 20X3
Harbour View Apartments
The contract price was $940,000 and costs were originally estimated at $800,000. At
the end of 20X3, the project was 80% completed, but price declines on materials
resulted in costs of only $600,000. Progress billings were sent out for $470,000, of
which $310,000 had been received at the year-end.
In 20X4, the project was completed with additional costs of $150,000. The customer paid the full contract price by November 20X4.
Sunnyside Curling Rink
The contract was awarded at $1,425,000 and costs were estimated at $1,250,000. At
the end of 20X3, the project was 20% completed, and costs were on target at
$250,000. Progress billings had been sent for $200,000 and one half had been
received by 31 December 20X3.
The contract was completed in 20X4. Costs were higher than estimated because
of a subcontractor that delayed the project. Completed contract income of $148,000
is included in income, and all of the contract price was received from the customer
before 31 December 20X4.
Started in 20X4
Victoria Mall
This contract for a three-unit mall was completed in 20X4. The contract price of
$450,000 has been billed, but $70,000 has not been received. Total costs of $423,000
were incurred.
DaVinci Apartments
The contract price was $1,825,000 and costs were estimated at $1,500,000 At the
end of 20X4, the project was 15% completed and actual costs included in construction in progress were $225,000. Although progress billings were sent out for
$150,000, nothing had been received by 31 December 20X4.
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Discount Don’s Department Store
The contract was awarded in November 20X4, but no construction has started. The
cost of preparing the bid was $9,000 and this has been included in general and
administrative expenses.
EXERCISES
E6-1 Revenue Recognition: Answer each of the following questions.
1. Define revenue.
2. What should be the dollar amount of revenue recognized in the case of (a) product sales and services for cash and (b) product sales and services rendered in
exchange for non-cash considerations?
3. How might revenue be recognized when there is a highly speculative transaction
involving potential revenue whose amount cannot be reliably estimated?
4. When should revenue be recognized in the case of long-term, low down-payment
sales, for which collectibility is uncertain?
5. When should revenue be recognized for long-term construction contracts?
E6-2 Revenue Recognition: For each of the following independent items, indicate
when revenue should be recognized.
a. Interest on loans made by a financial institution, receivable in annual payments.
b. Interest on loans made by a financial institution, receivable in three years when
the customer, who has an excellent credit rating, will make payment.
c. Interest on loans made by a financial institution, where the loans are in default
and payment of principal and interest is highly uncertain.
d. Recognition of revenue from the cash sale of airline tickets, where the travel purchased will occur in the next fiscal period.
e. Transportation of freight by a trucking company for a customer; the customer is
expected to make payment in accordance with the terms of the invoice in 60 days.
f. Growing, harvesting, and marketing of Christmas trees; the production cycle is
10 years.
g. Building houses in a subdivision, where the project will take two years to complete and each house must be individually sold by the contractor.
h. Building houses in a subdivision, where the project will take two years to complete and the contractor is building the houses under a contract from the local
government.
i. Selling undeveloped lots for future retirement homes in a western province, with
very low down-payment and long-term contracts.
j. Sale of a two-year parking permit by a Montreal parking garage, with one-half
the sale price received on the sale, and the remainder to be received in equal
monthly payments over the period of the permit.
k. A fixed-price contract with the government to design and build a prototype of a
space arm; the costs to complete the project cannot be reliably estimated.
l. A silver-mining company produces one million ounces of silver but stores the silver in a vault and waits for silver prices to increase.
E6-3 Revenue Recognition — Four Cases: The York Lumber Company has been
involved in several transactions that require interpretation of the revenue principle.
For each of the following 20X5 transactions, write a brief one- or two-paragraph
explanation, stating
280
1. the amount of revenue that you believe should be recognized during 20X5, and
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2. an explanation of the basis for revenue recognition.
a. The value of goods delivered to customers was $500,000, of which twothirds was collected by the end of 20X5; the balance will be collected in
20X6.
b. Regular services were rendered on credit amounting to $290,000, of which
three-fourths will be collected in 20X6.
c. An item that had been repossessed from the first purchaser and carried in
inventory at $4,000 was sold again for $5,000 in 20X5. A $3,000 cash
down-payment was received in 20X5. The balance is to be paid on a quarterly basis during 20X6 and 20X7. Repossession again would not be a surprise.
d. On 1 January 20X4, the company purchased a $10,000 note as a speculative
investment. Because the collectibility of the note was highly speculative, the
company was able to acquire it for $1,000 cash. The note specifies 8% simple interest payable each year (disregard interest prior to 20X4). The first collection on the note was $1,500 cash on 31 December 20X5. Further collections continue to be highly speculative.
E6-4 Revenue Recognition — Three Cases: Three independent cases are given
below for 20X5. The accounting period ends 31 December.
Case A. On 31 December 20X5, Zulu Sales Company sold a special machine (serial no. 1713) for $100,000 and collected $40,000 cash. The remainder plus 10%
interest is payable 31 December 20X6. Zulu will deliver the machine on 5 January
20X6. The buyer has an excellent credit rating.
Case B. On 15 November 20X5, Victor Cement Company sold a ton of its product for $500. The cement was delivered on that date. The buyer will pay for the product with two units of its own merchandise that are commonly sold for $250 each. The
buyer promised to deliver the merchandise around 31 January 20X6.
Case C. On 2 January 20X5, Remer Publishing Company collected $900 cash for
a three-year subscription to a monthly magazine, Investor’s Stock and Bond
Advisory. The March 20X5 issue will be the first one mailed.
Required:
Write a brief report covering the following:
1. The revenue recognition method that should be used.
2. Any entry that should be made on the transaction date.
3. An explanation of the reasoning for your responses to (1) and (2).
E6-5 Entries for Critical Events: Mylar Industries imports goods from the People’s
Republic of China and resells them to domestic Canadian markets. Mylar uses a perpetual inventory system. A typical transaction stream follows:
8 July
14 August
30 August
22 November
Purchased goods for $356,000 (Canadian dollars)
Goods repackaged and ready for sale. Cost incurred, $59,500
Goods delivered to customer. Agreed-on price, $612,000
Customer paid
Required:
1. Prepare journal entries assuming the following critical events:
a. Delivery to customer
b. Cash receipt
c. Preparation of goods for resale
2. Explain the circumstances under which each of these methods would be appropriate.
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E6-6 Entries for Critical Events: Dominum Corporation is a mining company that
mines, produces and markets teledine, a common mineral substance. The mineral is
mined and produced in one large batch per year, as the mine is only accessible for a
brief period in the summer due to severe weather conditions at the mine site.
Transactions in 20X6:
30
30
15
25
August
September
October
October
146,000 tons of ore removed from mine, at a cost of $3,400,000
Ore refined to 75,000 tons of teledine, at a cost of $416,000
Teledine delivered to 20 customers, total contract price, $ 8,675,000
Teledine returned for full credit; ore improperly refined and teledine
unusable; customer given full credit for $375,000 and unusable product scrapped. No other returns are anticipated.
30 November Customers all paid except one that went bankrupt still owing $76,000
Required:
1. Prepare journal entries assuming the following critical events:
a. 30 September
b. 15 October
c. 25 October
Assume at each of these dates that the company can make appropriate, accurate
accruals for future events such as sales returns and bad debts, if needed.
2. Explain the point at which net assets change for each alternative in requirement
(1).
3. Explain the circumstances under which revenue recognition at each of these dates
would be appropriate.
E6-7 Critical Event; Financial Statements: In each case below, several balance
sheet accounts are presented. Determine, based on this information, the likely point
at which revenue has been recognized.
Case A
Inventory, at market value
Accrued selling costs
Allowance for estimated sales returns
$367,300
31,900
16,400
Case B
Accounts receivable
Allowance for doubtful accounts
Inventory, at cost
Warranty liability
$2,567,700
359,100
1,876,400
341,100
Case C
Inventory, at cost
Accounts receivable
Allowance for doubtful accounts
Deferred gross margin
$ 566,300
1,040,000
119,600
249,700
E6-8 Unconditional Right of Return: In 20X5, McLaughlin Novelty Corporation
developed a new product, an electric shoe tree. To increase acceptance by retailers,
McLaughlin sold the product to retailers with an unconditional right of return, which
expires on 1 February 20X6. McLaughlin has no basis for estimating returns on the
new product. The following information is available regarding the product:
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Sales — 20X5
Cost of goods sold — 20X5
Returns — 20X5
Returns — January 20X6
$180,000
120,000
12,000
15,000
(cost, $8,000)
(cost, $10,000)
All sales are on credit. Cash collections related to the sales were $40,000 in 20X5 and
$113,000 in 20X6. McLaughlin uses a perpetual inventory system.
Required:
Include the entry made on 1 February 20X6 when the right of return expires. Give
journal entries for sales, returns, and collections related to the new product. How
much sales revenue should McLaughlin recognize in 20X5?
E6-9 Instalment Sales Method: Barr Machinery Corporation had credit sales of
$55,000 in 20X5 that required use of the instalment method. Barr’s cost of merchandise sold was $44,000. Barr collected cash related to the instalment sales of
$25,000 in 20X5 and $30,000 in 20X6. A perpetual inventory system is used.
Required:
1. What circumstances would dictate use of the instalment sales method?
2. Give journal entries related to the instalment sales for 20X5 and 20x6.
3. Give the ending 20X5 balances in the following accounts: instalment accounts
receivable, instalment sales revenue, cost of instalment sales, and deferred gross
margin on instalment sales.
E6-10 Cost Recovery Method: The Trusett Merchandising Company has an inventory of obsolete products that it formerly stocked for sale. Efforts to dispose of this
inventory by selling the products at low prices have not been successful. At the end
of the prior year (20X4), the company reduced the value to a conservative estimate
of net realizable value of $22,000. On 1 March 20X6, Watson Trading Company
purchased this entire inventory for $10,000 cash as a speculative investment. Watson
hopes to be able to dispose of it in some foreign markets for approximately $30,000.
However, prior to purchase, Watson concluded that there was no reliable way to estimate the probable profitability of the venture. Therefore, Watson decided to use the
cost recovery method. Subsequent cash sales have been as follows: 20X6, $4,000;
20X7, $5,000; and 20X8, $8,000. Approximately 12% of the inventory remains on
hand at the start of 20X9.
Required:
Give the 20X6, 20X7, and 20X8 entries for Watson Trading Company to record revenues and cost of sales.
E6-11 Completed-Contract and Percentage-of-Completion Methods Compared:
Watson Construction Company contracted to build a plant for $500,000.
Construction started in January 20X4 and was completed in November 20X5. Data
relating to the contract are summarized below:
Costs incurred during year
Estimated additional costs to complete
Billings during year
Cash collections during year
20X4
$290,000
125,000
270,000
250,000
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20X5
$120,000
230,000
250,000
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Required:
1. Give the journal entries for Watson in parallel columns, assuming (a) the completed contract-method and (b) the percentage-of-completion method. Use costs
incurred to date divided by total estimated construction costs to measure percent
completed.
2. Complete the following table:
CompletedPercentage-ofcontract method completion method
Income statement:
Income:
20X4
20X5
Balance sheet:
Receivables:
20X4
20X5
Inventory — construction in progress,
net of billings:
20X4
20X5
$
$
$
$
$
$
$
$
$
$
$
$
E6-12 Completed-Contract and Percentage-of-Completion Methods Compared:
Mullen Construction Company contracted to build a municipal warehouse for the
city of Moncton for $750,000. The contract specified that the city would pay Mullen
each month the progress billings, less 10%, which was to be held as a retention
reserve. At the end of the construction, the final payment would include the reserve.
Each billing, less the 10% reserve, must be paid 10 days after submission of a billing
to the city. Transactions relating to the contract are summarized below:
20X4
20X5
20X6
Construction costs incurred during the year, $200,000; estimated costs to
complete, $400,000; progress billing, $190,000; and collections per the
contract.
Construction costs incurred during the year, $350,000; estimated costs to
complete, $115,000; progress billings, $280,000; and collections per the
contract.
Construction costs incurred during the year, $100,000. The remaining
billings were submitted by 1 October and final collections completed on 30
November.
Required:
1. Complete the following table:
Net
income
recognized
Year
Method
20X4
Completed
contact
$
Contract
receivables,
ending balance
Construction-inprogress inventory,
ending balance
$
$
Percentage of
completion*
(continued)
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Problems
20X5
Completed
contract
Percentage of
completion*
20X6
Completed
contract
Percentage of
completion*
* Use costs incurred to date divided by total estimated construction costs to measure
percentage of completion.
2. Explain what causes the ending balance in construction-in-progress to be different for the two methods.
3. Which method would you recommend for this contractor? Why?
E6-13 Completed-Contract and Percentage-of-Completion Methods Compared:
Pedlar Construction Company contracted to build an apartment building for
$2,800,000. Construction began in October 20X4 and was scheduled to be completed in April 20X6. Pedlar has a 31 December year-end. Data related to the contract
are summarized below:
20X4
Costs incurred during year
Estimated additional costs to complete
Billings during year
Cash collections during year
20X5
20X6
($ thousands)
$ 400
$1,500
$ 700
2,200
400
—
350
1,450
1,000
325
1,300
1,175
Required:
1. Prepare the journal entries for Pedlar, assuming the completed-contract method.
2. Prepare the journal entries for Pedlar, assuming the percentage-of-completion
method. Use costs incurred to date divided by total estimated construction costs
to measure percent complete. Round your estimate of revenue to the nearest
thousand.
P6-1 Revenue Recognition: Assume that in 20X5, the Public Utilities Board (PUB)
PROBLEMS
issued a ruling raising the ceiling price on regulated gas, but with a “vintaging” system: gas suppliers could charge $1.42 per thousand cubic feet on “new gas” drilled
after 1 January 20X5, and $1.01 on gas (now in inventory) drilled between 1 January
20X3, and 31 December 20X4. The old price had been 52 cents per thousand cubic
feet and remained at this for all “old” gas (i.e., pre-20X3 gas). The PUB soon reduced
the $1.01 rate to 93 cents but retained the $1.42 rate. As a result of a lawsuit by consumers against the PUB seeking a rollback to the old 52-cent rate, a court of appeal
decided that gas suppliers should go ahead and collect the higher prices provided they
would agree to refund the money if the final decision went against the PUB.
Required:
1. If you were part of the management of a gas supplier at the time of the court decision, what position would you take with respect to recognition of the extra amounts
of revenue from the sale of new gas? Give reasons for whatever position you take.
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2. Disregard the answer you gave to (1) above. If the revenue is deferred, explain
how the deferral would affect the financial statements until a final court decision
is rendered. How would the deferred revenue be recognized if the final court
decision is delayed until a new accounting year and then is favourable?
P6-2 Magazine Subscription Revenue: At a meeting of the board of directors of
Vanguard Publishing Company, where you are the controller, a new director
expressed surprise that the company’s income statement indicates that an equal proportion of revenue is earned with the publication of each issue of the magazines the
company publishes. This director believes that the most important event in the sale
of magazines is the collection of cash on the subscriptions and expresses the view that
the company’s practice smoothes its income. He has suggested that subscription revenue should be recognized as subscriptions are collected.
Required:
Discuss the propriety of timing the recognition of revenue on the basis of
1. Cash collections on subscriptions.
2. Publication of issues, concurrent with delivery to customers.
3. Both events, by recognizing part of the revenue with cash collections of subscriptions and part with delivery of the magazines to subscribers.
[AICPA adapted]
P6-3 Revenue Recognition: Scientific Development Company (SDC) conducts
research and development on specific projects under contract for clients; SDC also
conducts basic research and attempts to market any new products or technologies it
develops.
In January 20X4, scientists at SDC began research to develop a new industrial
cleaner. During 20X4, $1,560,000 of costs were incurred in this effort. Late in July
20X5, potentially promising results emerged in the form of a substance the company
called Blast. Costs incurred through the end of July 20X5 were $840,000. At this
point, SDC attempted to sell the formula of and rights to Blast to Pride and Glory
Industries Ltd. (P&G), for $10,000,000. P&G, however, was reluctant to sign before
further testing was done. It did wish, though, to have the first option to acquire the
rights and formulas to Blast if future testing showed the product to be profitable.
SDC was very confident that Blast would pass further testing with flying colours.
Accordingly, the two companies signed an option agreement that allowed P&G to
acquire the formulas and rights to Blast anytime before 31 December 20X6. Testing
costs on the product incurred by SDC for the remainder of 20X5 amounted to
$1,080,000.
In early 20X6, P&G exercised its option and agreed to purchase the formulas and
rights to Blast for $10,000,000. P&G paid $500,000 immediately with the balance
payable in five equal annual instalments on 31 December 20X6 to 20X10. The formula was to be completed and delivered within 18 months.
In April 20X7, SDC delivered the formulas and samples of Blast to P&G
Industries. Additional costs incurred by SDC during 20X6 amounted to $360,000; in
20X7, $120,000.
Required:
1. When should revenue be recognized by SDC from its work on Blast? Why?
2. Assume that the total costs of $3,960,000 actually incurred by SDC over the
years 20X4 to 20X6 were accurately estimated in 20X4. Determine the amount
of revenue and expense that should be recognized each year from 20X4 to
20X10, assuming revenue is to be recognized
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Problems
a.
b.
c.
d.
At the time the option is signed.
At the time the option is exercised.
At the time the formulas are delivered.
As cash is collected (use the instalment method).
Note that the $1,560,000 of research costs must be expensed in all alternatives
to comply with accounting standards for research costs. Other costs may be
deferred if appropriate. Do not attempt to do journal entries; your solution
should focus on income statement presentation.
P6-4 Unconditional Right of Return: McLaughlin Novelty Corporation developed
an unusual product, electric clip-on eyeglass wipers. McLaughlin felt the product
would appeal to hikers, joggers, and cyclists who engaged in their sports in rainy climates. Because retail establishments were skeptical about the market appeal of the
product, McLaughlin sold the product with a declining unconditional right of return
for up to 10 months, with 10% of the right-of-return amount of the purchase expiring each month for 10 months. Thus, after the retailer had the product for one
month, only 90% could be returned. After two months, only 80% could be returned,
and after 10 months, the right of return was fully expired.
McLaughlin had no basis for estimating the amount of returns. Consistent with
the terms McLaughlin offered its customers, all retailers paid cash when purchasing
the clip-on eyeglass wipers but received cash refunds if goods were returned.
McLaughlin had its first sales of the product in September 20X5. Sales for the
remainder of the year, and returns prior to 31 December 20X5, were as follows:
Month of Sale
September
October
November
December
Totals
Units Sold
10,000
12,000
15,000
11,000
Sales Price
$10
10
12
12
48,000
Monthly Sales
$100,000
120,000
180,000
132,000
Units Returned
2,500
1,000
1,000
0
$532,000
4,500
Each unit of product costs McLaughlin $6 to produce.
Required:
1. Show the journal entries to record the four months of sales transactions, including the deferral of gross margin. Prepare one summary entry.
2. Show a summary entry to record the returns in 20X5.
3. Compute the amount that McLaughlin can record as (realized) sales for 20X5.
How much is gross margin? Record the revenue recognition entry.
4. For the above transactions, total returns in all of 20X6 were as follows:
Month of Sale
September
October
November
December
Units Returned
1,000
2,000
2,500
4,000
Show the entries to record the returns in 20X6 and to record sales revenue and cost
of sales from the 20X5 shipments of this product.
P6-5 Revenue Recognition: Fly and Mattox, a professional corporation, contracted to provide, as required, all legal services for Brown Company until the end of
20X5. The contract specified a lump-sum payment of $60,000 on 15 November
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20X4. Assume that Fly and Mattox can reliably estimate future direct costs associated with the contract. The following services were performed based on the estimate by
Fly and Mattox:
Research potential lawsuit
Prepare and file documents
Serve as Brown’s counsel during legal
proceedings
Direct Costs
$ 5,000
15,000
15,000
Date Completed
15 December 20X4
1 March 20X5
15 October 20X5
Required:
1. When should Fly and Mattox recognize revenue in this situation? Explain.
2. Give entries to recognize revenues related to this contract for Fly and Mattox.
P6-6 Critical Event: BC Corporation sells large pieces of construction equipment.
The company had the following three sales in 20X5:
Byron Foods
Sales
Amount
$345,700
Cost of
Goods Sold
$210,000
Addison Roads
$
?
$166,800
Price to be determined after
Addison has use of the equipment for six months: to be
determined based on revenue
generated and operating
costs. BC believes that the
sales price will likely be in the
range of $200,000 to
$230,000, but has no previous
experience with this kind of
contract.
Carson
Construction
$567,000
$399,000
Collection contingent on
Carson’s continued operations; company close to bankruptcy. Title to equipment still
in BC’s name so that assets
would not be lost in bankruptcy; Carson paid $50,000 up
front as security. Balance to
be paid within 12 months.
Other Information
Unlimited right of return until
30 June 20X6. Extent of
returns is not estimable.
Required:
1. At what point should BC recognize revenue for each of the above sales transactions?
2. Show how the transactions would be reflected in the 20X5 balance sheet and
income statement.
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P6-7 Critical Event: Manzer Manufacturing had transactions in 20X6 as follows:
30 June
17 July
Purchased inventory, $378,000.
Sale to customer, $271,000, on account. Cost of goods sold,
$164,500.
15 September
Customer returns $29,000 of goods for full credit; goods were
spoiled and worthless.
30 November
Warranty work of $20,000 was performed.
15 December
Customer paid all outstanding amounts.
All goods were sold with unlimited right of return for 60 days and a one-year warranty.
Required:
1. Prepare 20X6 entries to record the above transactions assuming that the critical
event is deemed to be
a. the date of delivery
b. the date that the warranty expires
c. the date that the return privilege expires
If necessary, assume that total warranty cost can be estimated to be $41,000, and
returns, $29,000.
2. Show how the income statement and balance sheet would reflect each of the alternatives in (1).
3. Comment on the relative timing of the increase in net assets.
P6-8 Instalment Sales: Baxter Land Corporation made a number of sales in 20X4
and 20X5 that required use of the instalment method. The following information
regarding the sales is available:
Instalment sales
Cost of instalment sales
Collections on 20X4 sales
Collections on 20X5 sales
20X4
$200,000
160,000
40,000
20X5
$150,000
112,500
50,000
30,000
20X6
0
0
60,000
75,000
$
Baxter uses a perpetual inventory system.
Required:
1. Give journal entries relating to instalment sales for the years 20X4 to 20X6.
2. What is the year-end balance in instalment accounts receivable (net of any
deferred gross margin) for 20X4, 20X5, and 20X6?
3. If the sales qualified for revenue recognition on the date of sale (i.e., delivery),
what amounts of gross margin would Baxter report in 20X4, 20X5, and 20X6?
P6-9 Instalment Sales Method: Ontario Retail Company sells goods for cash, and
on normal credit terms of 30 days. However, on 1 July 20X4, the company sold a
used computer for $2,200; the inventory carrying value was $440. The company collected $200 cash and agreed to let the customer make payments on the $2,000 whenever possible during the next 12 months. The company management stated that it had
no reliable basis for estimating the probability of default. The following additional
data are available: (a) collections on the instalment receivable during 20X4 were
$300 and during 20X5 were $200, and (b) on 1 December 20X5, Ontario Retail
repossessed the computer (estimated net realizable value, $700).
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Revenue Recognition
Required:
1. Give the required entries for 20X4 and 20X5; assume that the instalment method
is used.
2. Give the balances in the following accounts that would be reported on the 20X4
and 20X5 income statements and balance sheets: instalment sales revenue and
cost of sales, instalment accounts receivable, and inventory of used computers.
3. How much profit would be recognized in 20X4 and 20X5 if the cost recovery
method is used?
P6-10 Cost Recovery Method: Slatt Department Store has accumulated a stock of
obsolete merchandise. Routine efforts have been made to dispose of it at a low price.
This merchandise originally cost $60,000 and was marked to sell for $132,000.
Management decided to set up a special location in the basement to display and (it
was hoped) sell this stock starting in January 20X5. All items will be marked to sell
at a cash price that is 30% of the original marked selling price. On 31 December
20X4, the company accountant transferred the purchase cost to a perpetual inventory account called “inventory, obsolete merchandise,” at 30% of its purchase cost,
which approximates estimated net realizable value. Management knows that a reliable estimate of the probable sales cannot be made. Therefore, the cost recovery
method will be used. Subsequent sales were $9,000 in 20X5 and $7,000 in 20X6, and
in 20X7 the remaining merchandise was sold for $8,000.
Required:
Give the entries that Slatt should make for 20X4 through 20X7.
P6-11 Long-Term Construction — Percentage-of-Completion Method: Thrasher
Construction Company contracted to construct a building for $975,000. The contract provided for progress payments. Thrasher’s accounting year ends 31 December.
Work began under the contract on 1 July 20X5, and was completed on 30 September
20X7. Construction activities are summarized below by year:
20X5 Construction costs incurred during the year, $180,000; estimated costs to
complete, $630,000; progress billings during the year, $153,000; and collections, $140,000.
20X6 Construction costs incurred during the year, $450,000; estimated costs to
complete, $190,000; progress billing during the year, $382,500; and collections, $380,000.
20X7 Construction costs incurred during the year, $195,000. Because the contract
was completed, the remaining balance was billed and later collected in full
per the contract.
Required:
1. Give Thrasher’s entries assuming that the percentage-of-completion method is
used. Assume that percentage of completion is measured by the ratio of costs
incurred to date divided by total estimated construction costs.
2. Prepare income statement and balance sheet presentation for this contract by
year; assume that the percentage-of-completion method is used.
3. Prepare income statement and balance sheet presentation by year; assume that
the completed-contract method is used. For each amount that is different from
the corresponding amount in (2), explain why it is different.
4. Which method would you recommend to this contractor? Why?
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Problems
P6-12 Long-Term Construction: Methods Compared: Wallen Corporation contracted to construct an office building for Ragee Company for $1,000,000.
Construction began on 15 January 20X4, and was completed on 1 December 20X5.
Wallen’s accounting year ends 31 December. Transactions by Wallen relating to the
contract are summarized below:
20x4
$400,000
420,000
410,000
375,000
Costs incurred to date
Estimated costs to complete
Progress billings to date
Progress collections to date
20x5
$ 850,000
—
1,000,000
1,000,000
Required:
1. In parallel columns, give the entries on the contractor’s books; assume
a. the completed contract method, and
b. the percentage-of-completion method.
Assume that percentage of completion is measured by the ratio of costs incurred
to date divided by total estimated construction costs.
2. For each method, prepare the income statement and balance sheet presentation
for this contract by year.
3. What is the nature of the item “costs in excess of billings” that would appear on
the balance sheet?
4. Which method would you recommend that the contractor use? Why?
P6-13 Percentage-of-Completion and Completed-Contract Methods: Banks
Construction Company contracted to build an office block for $3,200,000.
Construction began in September 20X4 and was scheduled to be completed in May
20X6. Banks has a 31 December year-end. Data related to the contract are summarized below:
20X4
Costs incurred during year
Estimated additional costs to complete
Billings during year
Cash collections during year
$ 500
2,500
450
400
20X5
($ thousands)
$1,800
800
1,300
1,100
20X6
$ 850
0
1,450
1,700
Required:
1. Prepare the journal entries for Banks, assuming the completed-contract method.
2. Prepare the balance sheet and income presentation for this contract by year,
assuming the completed-contract method is used.
3. Prepare the journal entries for Banks, assuming the percentage-of-completion
method. Use costs incurred to date divided by total estimated construction costs
to measure percent complete.
4. Prepare the balance sheet and income presentation for this contract by year,
assuming the percentage-of-completion method is used.
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